Over the last few years, the quick-service restaurant industry has experienced a decline in profit margins, which has significantly impacted both quick-serve brands and franchise operators.
One of the primary reasons for the decrease in profit margins is the intense competition in the industry. With the rise of new entrants, brands are losing their market share and are struggling to keep up with the increased competition. Additionally, consumers have become more health conscious, which has forced restaurants to introduce healthier menu options that are less profitable than traditional fast-food items.
Another factor contributing to this trend is the rise in operating costs. Quick-service chains are facing increasing pressure to provide a higher standard of service, which requires investing in new technologies and equipment. Additionally, brands are facing rising labor costs due to minimum wage hikes and difficulty finding and retaining skilled workers.
Moreover, the COVID-19 pandemic has had a significant impact as well. With the restrictions on indoor dining, restaurants had to rely on takeout and delivery services, which are less profitable than in-store dining. The pandemic also caused supply chain disruptions, increasing the cost of raw materials and ingredients, further squeezing profit margins.
The impact on franchise operators:
The decline in profit margins of quick-service brands significantly impacts franchise operators (franchisees). Franchisees are independent business owners who pay a fee to a chain (franchisor) to operate their own franchise location. They rely on the profitability of their business to earn a return on their investment and maintain their operations.
When quick-service brands experience a decrease in profit margins, franchisees feel significant effects. Typically, franchisees pay a percentage of their revenue as royalties to the franchisor. The average royalty percentage for a quick-service restaurant franchise is 5.2 percent of revenue, which means profits on goods sold are tightening, a royalty fee based on pure revenue (not profit after costs) can become a large financial burden. As a result, franchise operators may find it difficult to meet their other financial obligations, such as rent, payroll, and supplies.
Additionally, when franchisors implement cost-cutting measures to address declining profit margins, franchise operators are often required to bear the brunt of these measures. For example, quick-service brands may reduce menu offerings or decrease marketing spending, negatively impacting franchise sales. Franchise operators may also be asked to reduce their expenses, remodel stores, or invest in new technology, all of which are significant financial burdens.
The decline in profit margins can also impact the relationship between the quick-serve and franchise operators. When franchise operators struggle to maintain profitability, they may become dissatisfied with the support they receive from the restaurant. This can lead to conflicts over issues such as marketing, supply chain management, pricing strategies, and royalty fees. In some cases, franchise operators may even decide to terminate their franchise agreement or pursue legal action against the quick-service brand if they feel that their profitability has been negatively impacted. This can be a significant loss for both the franchisee and franchisor, as it can damage their reputation and result in major losses in revenue.
Overall, the decrease in profit margins of restaurants has a significant impact on franchise operators, who rely on the profitability of their businesses to succeed. It also poses a significant challenge for chains that must find new ways to remain competitive and profitable in a rapidly changing industry. The quick-service industry will need to continue to innovate and adapt to meet the changing demands of consumers and overcome these challenges.
Why this is important to an STNL Investor:
Single tenant net lease investing is a popular option for commercial real estate investors as it requires very little management (typically, the tenant is responsible for paying for expenses related to the property, such as property taxes, insurance, and maintenance). However, when it comes to investing in this property type, it is essential to understand that most of the value in the property is tied to the lease and, in particular, the tenant. As such, it is crucial to consider the challenges the tenant and the larger brand/franchisor face. For example, if a quick-service brand is experiencing a decline in profit margin, it could result in financial strain for the franchise operators and potentially lead to them defaulting on their lease obligations, directly devaluing your property. This exact scenario was showcased by the closure of 26 Burger Kings in Michigan.
By understanding the challenges the tenant and the larger brand/franchisor face, investors can better assess the risks and opportunities associated with investing in a single tenant net lease property. It is essential to consider more than just the store sales and the strength of the guarantee; the brand's market position, its growth potential, and its financial stability, as well as the current state of the industry, are crucial factors to understand in order to make informed decisions and mitigate potential risks associated with these properties.
Erik Vogelzang is an Associate Vice President at Matthews Real Estate Investment Services, specializing in single tenant net lease properties across the U.S. He has an extensive client base, working alongside developers, REITs, corporations, franchise operators, and private investors to execute seamless transactions, positioning his clients for the greatest long-term financial success.