By Taylor Williams
Well before a global pandemic barreled through the nation, destroying the jobs, savings and legacies of thousands of American businesses, launching a new restaurant was still a daunting task.
According to 2021 data from National Restaurant Association, 30 percent of U.S. restaurants fail within their first year of opening. Relentless competition, high employee turnover, razor-thin margins, misfired marketing campaigns — all represent major operating minefields that come with such ventures. The industry is not for faint-of-heart entrepreneurs, and even with the aid of a healthy economy, a talented and experienced operator and a prime location, there are no guarantees of success.
One might think that with COVID-19 causing food and beverage (F&B) businesses to fail and sending vacated spaces back to the market, finding quality locations at affordable rates would be feasible in the current environment. But that’s hardly the case in many major cities, especially those in states that implemented life-saving initiatives for its F&B operators early in the pandemic and has been “back to normal” for some time.
Minimal Vacancy
While F&B markets across numerous states are flush with pent-up consumer demand to eat, drink and socialize, the logistical and financial challenges of launching or expanding in the current environment are keeping some operators on the sidelines.
“At this point in spring of 2022, almost all of the well-located, high-quality restaurant spaces that were returned to the market due to COVID have been re-tenanted,” says Paul Vernon, executive vice president of retail at Henry S. Miller Brokerage. “In Dallas-Fort Worth (DFW), not as many restaurants failed as expected, and many users held on to their spaces, so turnover hasn’t been as high. Consequently, rents have held their value, if not gone up.”
“For tenants that have their financing in place, not much has changed except for the fact that there’s a shortage of quality restaurant space, though there is more Class B and C product on the market,” Vernon continues. “Construction of new retail space has been slow to pick back up in DFW, which further limits expansion opportunities, so it’s hard for new restaurateurs to find locations they like and can afford.”
Similar conditions exist in Houston and Austin. Vacancy rates are down, and rents for well-located, turnkey restaurant spaces are up relative to this time in 2021, sources say. But natural upward pressure on rents is hardly the only cost driver facing F&B operators looking to launch or expand their concepts.
“In Austin, we normally have annual turnover of 60 to 80 restaurants per year — not just going out of business, but leases expiring or voluntary decisions to close,” says Britt Morrison, senior vice president in Weitzman’s Austin office. “A few months into COVID, 65 restaurants had closed. But 180 days later, we were at an all-time low of supply of second-generation spaces. Those that came back to market were absorbed quickly.”
Morrison also says that in Austin, one of the hottest F&B scenes in the country thanks to a growing population of young, gainfully employed residents, the lack of available space means that most restaurant deals that do get done are off-market transactions. Brokers know well in advance if a tenant is going to vacate a space due to relocation, downsizing or lease expiration. As such, deals to backfill those spaces are put together in advance of the actual closing and usually without the site being formally listed as available for lease.
Stalled Rent Collection
In addition to basic construction materials, opening a new restaurant requires ordering large, sophisticated pieces of equipment that may be manufactured overseas. Specialized labor is often required to install these machines as well.
Global supply chain disruption has added to delivery times for these products via logjams at major ports of entry. A national labor shortage raises the likelihood that the qualified technicians needed to install this equipment are overworked and understaffed. Both of these factors are adding significant delays to launching new concepts. As a result, brokers find themselves adjusting the typical language in lease agreements that pertains to commencement of rent payments in order to protect their operator clients.
“Supply chain issues are changing the ways deals happen,” says Emily Durham, partner and director of hospitality services at Houston-based Waterman Steele Real Estate Advisors. “For example, right now it takes about eight months to have a new walk-in cooler delivered and installed.”
“In the past, we would work to structure deals in which tenants’ rent commencement was tied to when they got their building permits,” she continues. “Now we need to ask for contingencies for commencement of rent [payment] based on availability and length of time for equipment delivery.”
“We currently have a number of landlords that aren’t putting timelines on opening or collecting rent, mainly because tenants’ equipment is sitting on a carrier in the ocean thousands of miles away,” adds Morrison. “Instead, landlords are incorporating loose language about tenants using ‘best measures
possible’ to get up and running and start paying rent.”
Of course, time and money rarely move inversely. What takes longer to arrive costs more upon receipt of delivery. To that end, soaring fuel prices — part of a 40-year inflationary high — ensure that the costs of delivering those items have increased considerably, throwing yet another kink into the operation.
David Littwitz, president of Houston-based brokerage firm Littwitz Investments Inc., says that in order to get a better handle on an operator’s financial performance and more effectively map out a timeline for rent payment, landlords are now pushing harder for tenants to report sales.
Required sales reporting is nothing new. But after restructuring numerous deals to reflect percentage-based rents during the pandemic and facing longer lead times to get cash flowing if a space goes dark, landlords are now looking for a little more operational clarity.
“In certain deals, tenants will pay triple-nets once they take possession of the space — but not always,” says Littwitz. “So it’s a question of how long the landlord is willing to wait. Some landlords have added clauses whereby they are not charging percentage rents but requiring reporting of sales quarterly or annually. They push hard for that so they actually know how a tenant is doing.”
Littwitz adds that this practice is particularly common among landlords that may be looking to sell their properties. These owners want to be able to present their properties in the best possible light with the best possible net operating income figures — and therefore the lowest possible cap rates — to prospective buyers.
In terms of restaurant lease negotiations, it’s still a landlord’s market for quality spaces in major Texas cities. Competition between restaurateurs searching for new locations is stiff. In addition, on lease renewals, if restaurateurs don’t have caps on their renewal options, they will be in for a fight to keep their rents from increasing less than 3 percent per year, notes Vernon, who also concurs that timelines for opening are being heavily stretched.
“It used to take a restaurant, on average, four to six months to open from the time a lease was signed,” he says. “Now it’s more like six to eight. Unfortunately, landlords are reluctant to wait, so it’s a hard sell.”
“The reasons behind the increase in the time it takes to open can include the fact that most architects aren’t taking on new clients because they’re overwhelmed and understaffed,” Vernon continues. “So it takes longer to get drawings and blueprints. Then you go to the city, which has probably lost a couple people who reviewed plans or issued permits. The combined effect is delayed construction schedules and opening dates. Then, to add insult to injury, there is still a shortage of kitchen equipment coming in from overseas.”
“The average timeline to open a new restaurant has easily doubled in the last 18 months,” adds Morrison. “Re-tenanting a space means incurring new costs and down time, but the flip side is that rental rates today are up 15 to 20 percent [from the start of the pandemic]. So landlords have a dilemma — take the down time and trust that the market will continue to appreciate at a crazy rate, or not have rent for 12 to 18 months.”
In some cases, interior buildouts for more affluent food and beverage concepts, such as Jonathan’s The Rub in Houston, can take longer than those of quick-service or fast-casual restaurants. Regardless the price point or ambiance of the concept, however, lead times and costs of getting new restaurants off the ground are rising across major markets.
It’s a peculiar conundrum, but ultimately the decision is a factor of how well-capitalized the landlord is. Major restaurant brands and ownership groups can afford to leave their spaces dark longer than mom-and-pop owners. Larger, more liquid owners have the luxury of allowing the natural healing power of time to mitigate supply chain disruption and rampant inflation. As such, franchised concepts have a bit of an advantage in this market.
“We’re seeing more franchising than ever,” says Durham. “The more well-capitalized the tenant or concept is, the easier it is to get the deal done. Everyone’s exposure is greater right now, so landlords are less apt to take risks on tenants with lesser credit or less of a track record.”
Brutal Buildouts
In addition to temporarily not generating income, the process of backfilling a space with a new tenant generally requires doing a fresh buildout, which is a bona fide cash killer these days. With costs of construction materials up and construction employment down (as always seems to be the case), operators are requiring more tenant improvement (TI) dollars from landlords to design and build out their spaces.
“The average cost of building out a restaurant space from shell condition in Houston is up 40 percent from
pre-pandemic levels,” says Durham. “As tenant reps, we’re requesting more in TI allowances, but there’s only so much landlords can give. Both sides and their investors have to hit their required rates of return. Some landlords with less attractive spaces have made concessions, but they’re now getting to the point where they can’t make any more.”
Sources say that landlords have come to grips with the fact that TI allowances that were essentially standard pre-pandemic — typically about $30 to $35 per square foot — simply won’t cut it in this market. To cover their exposure from providing more TI dollars, some landlords are asking for assurances that the tenant will spend at least double or even triple the value of the allowance on the total cost of the buildout. It’s yet another way in which the language of these agreements is changing on the fly.
“We’re seeing more and more that landlords are open to discussion on TI allowances based on the creditworthiness of the tenant,” says Littwitz. “The landlord might come up on TI allowances if the tenant can demonstrate financial credibility, operational strength and stability. That’s what we have to do as tenant reps to get more TI dollars.”
Littwitz offers anecdotal evidence of just how much TI allowances have risen. An unnamed client of his that fared relatively well during COVID-19 and is expanding in the Houston area recently opened a new restaurant at its standard footprint of about 7,000 square feet. The operator received $500,000 in TI money, or roughly $70 per square foot, but that ultimately only accounted for about 20 percent of the $2.5 million buildout.
Worth the Risk?
The narrative on F&B — and hospitality in general — users being strapped for labor is still very much accurate.
According to the 2022 State of the Industry report from the National Restaurant Association, which surveyed some 3,000 operators, seven out of 10 reported being understaffed relative to pre-pandemic levels. In addition, the vast majority (96 percent) of operators said that they expect their costs of labor — as well as food and other supplies — to continue to rise through 2022.
According to the monthly jobs report from the U.S. Bureau of Labor Statistics, the leisure and hospitality industry gained 112,000 jobs in March, including growth of 61,000 jobs in foodservices and drinking places. However, relative to its pre-pandemic level in February 2020, employment in the sector is still down 1.5 million workers, or 8.7 percent.
“Overall, labor is operators’ biggest problem right now,” says Littwitz. “Supply chain issues and price increases in food tend to settle over time. But when people walk into a restaurant of any type, they simply assume there are enough employees to give them the kind of service they expect. People will pay extra for menu items as long as they feel like the food and service don’t let them down.”
Littwitz also points out that labor is not only evaporating from the F&B industry on some level, but also migrating. Experienced employees are flocking to higher-end restaurants where customers can afford to spend more and tip better. And with each move up the ladder of affluence that cooks, servers, bartenders or hostesses make, the operator losing staff has to invest additional time and money in training new people.
“Operators are increasing weekly wages, offering sign-on bonuses and retention bonuses for staying employed for as little as three months, but it gets very expensive to constantly train new employees who leave for greener pastures a few months later,” he says. “This is a problem that operators will be confronting for a while.”
So what incentive is there to open a new restaurant right now? In a word, demand.
Sources say that despite the various and severe supply-side pressures, the power of pent-up demand for F&B-based experiences is extreme enough to prevail — even in an environment in which consumers’ discretionary incomes are quite stretched. It also bears mentioning that the reduced purchasing power of F&B patrons not only extends to menu items, but also to the elevated cost of driving to the bar or restaurant.
Yet the National Restaurant Association report estimated that total industry sales for 2022 are expected to be just shy of $900 billion, a roughly 22 percent increase over the 2021 sales figure of $731.5 billion. The 2022 sales figure, if recognized, would also be an increase of roughly 4 percent over the pre-pandemic total of $864 billion in 2019.
“People are spending a lot of money eating out and drinking again, and good operators are seeing record sales,” says Durham. “It reflects everyone’s desire to get back out. We don’t know how long consumers will tolerate higher food prices and slower service. But there’s no question that people are excited to get back out, and there are a lot of great operators that are killing it.”
“The customers are truly a lifeline; their demand is what keeps these restaurants ticking,” concludes Morrison. “Operators today that are opening new restaurants, knowing that it’s going to cost them double what they spent for their first and second restaurants — they wouldn’t do it if they weren’t seeing record sales and profits from the demand.”
— This article originally appeared in the May 2022 issue of Texas Real Estate Business magazine.