One of the COVID-19 schools of thought is that the crisis didn’t trigger the restaurant industry’s downturn in spots—it accelerated the need for fundamental change and innovation in the way operators reach customers. This is a notion Andy Lapin, a real estate attorney with nearly four decades of experience advising franchise owner/operators, investors, and developers, prescribes to.

“While the trend of restaurants not succeeding was hastened by the pandemic, longtime, mom-and-pop owners of quick-serve franchise restaurants were already being forced out so that larger franchise operators could come in to invest in store remodels and expansion,” Lapin says. “Franchisors are requiring major expenditures of capital for unit upgrades in their agreements as the franchise brands are being reimaged, and it’s not possible for smaller and older legacy owners to ever recoup this money.”

Call it the tip of the evolution iceberg. As sales recover, restaurants are finding a changed and savvier customer. And opportunities that were only boardroom whispers before.

For instance, Lapin believes we’ve only begun to see concepts partner with real estate developers on “centralized kitchens.” These venues consist of multiple kitchens and “address a range of issues,” he says. Owners can reduce expenses by not having to maintaining dining rooms and bathrooms.

“Deserted shopping centers can be revived by leasing out space, and food delivery will be more efficient and less costly for operators,” Lapin adds.

It’s been futile, and probably impractical, at times over the past year-plus to think clearly about what’s next. Firstly, there was only so much water in the hose to put out that day’s fires. But also, COVID shoved trends through the funnel at breakneck pace. So ideas that seemed sensible last June likely to be reevaluated again.

Lapin chatted with QSR about the current state of restaurants, how COVID benefited quick-serves in particular, and where the lines will be drawn between the winners and losers of a post-pandemic era.

Talk about the specific challenge for smaller, older legacy owners, and why this is ushering in larger franchise operators.

Fast-food franchising took off starting in the 1950s. In those days, franchisors wanted “mom and pop” operators to be the heart of their franchise systems. They reasoned that these small owner/operators would personally work the business at the store level getting the most out of each store location. Franchise agreements were drafted in such a way as to restrict franchisees from developing and expanding rapidly. Specifically, the franchise agreements did not allow private placement/syndicated partnership financing, public financing and conventional commercial lenders, who did not understand the fast food model so were not lenders to this market. The result: expansion could only be achieved by using cash generated by the operator’s existing restaurants or the operator’s own resources. It takes a lot of capital to develop a new location so development was very slow by any individual franchisees. The 1980s ushered in a new era in franchising. Franchisors started to rethink their strategy of expanding with “mom and pop” operators, and instead, started to focus development using larger, well-financed, multi-store operators.

Today, Franchisors are all about reinventing themselves to address the concerns of the next generation of customers, the millennials and their children. Millennials are focusing on eating what they perceive to be healthy food that is sourced in a humane and environmentally friendly way that they can obtain quickly with a minimal amount of hassle. As a result, franchisors are demanding that their franchisees reimage their existing stores and expand and develop new stores filling any perceived location gaps and new growth locations.

“Vacated real estate left behind by failing operators will be quickly repurposed into new restaurants to satisfy the development agreements that the large franchise operators were cajoled into signing,” Lapin says.
 

The cost of reimaging an existing location can be very costly—$250,000 up to $1 million or more per location. Developing a new store can cost upward of $2 million. Older, legacy franchisees look at the amount of money required and must decide if they have the energy and time to recoup this new investment. Add to this mix that, in many cases, the legacy owners’ children are not interested in the family business. And finally, there has been a substantial increase in the multiples being paid to obtain existing stores. Larger, well financed franchise operators are fighting each other for the chance to expand quickly. This can be accomplished by buying older legacy operator locations.

Add all of this up and there exists a perfect storm exit strategy for older, legacy franchise operators that allows them to reap the rewards of their many years of hard work.

What do you think happens with the vacated real estate left behind by some 90,000 or so closures? Will COVID open the door for entrepreneurial-minded growth, like fast casual in the Great Recession? Or will the big get bigger? Or something else?

Larger, well financed operators are taking over the fast-food model. Franchisees that want to buy out existing operators are being approved by franchisors, but part of the cost is a requirement to sign a development agreement. These development agreements require the acquiring operator to agree to develop more stores within certain designated areas within certain periods of time. Vacated real estate left behind by failing operators will be quickly repurposed into new restaurants to satisfy the development agreements that the large franchise operators were cajoled into signing.

Will there be a shift from private equity financing to family offices funding large franchise deals?

The issue I see most often with private equity financing is a lack of goal alignment between the ownership parties. Private equity likes quick serve restaurants. Or rather, they like the large cash flow generated by quick serve restaurants that they see as a source of leveraging. The more cash generated, the more credit that is potentially available to the business to borrow and ultimately use to buy them out. The typical private equity firm want to be in and out of the business within 4-7 years. The owner/operator, on the other hand, looks at the business as its long-term cash cow. They want to run the business indefinitely.

Thus, the disconnect. The private equity firm wants out in the short term while the owner/operator is in the business for the long term. And there lies the problem. The private equity player forces the owner/operator to buy it out at a substantial profit using the borrowed funds resulting in the business being over levered and a perfect candidate for failure when the market has a downturn and it no longer has cash or the ability to borrow to sustain itself. It is forced to sell.

Enter the family office. Family offices are, by their nature, typically “long term money.” Family offices usually are looking for investments that pay yields over a long period of time. This allows for the goal alignment that is lacking with private equity. I believe that family offices will become a good source of funding for quick serve restaurants moving forward.

What makes this current landscape so unique compared to 2008–2010? What are some major differences operators need to consider, especially growth-minded ones?

The world collapsed in 2008 and again in 2020. However, in 2008 the financial system collapsed causing major disruptions to business and consumers alike. In 2020 that is not the case. To the contrary. Financial institutions were much stronger going into 2020 than 2008, partly as a result of legislation that was enacted after 2008 forcing financial institutions to carry more reserves and take other conservative measures to ensure they would not collapse in a future calamity. In 2020, governments around the globe created instant and substantial liquidity to their economies and at the same time doled out money to support their consumers. As a result, consumers have substantial accumulated wealth and have decreased their debt. Add in the pent-up demand of having nothing much to do or spend on over the past year and the result is a booming economy.

Operators are looking to acquire existing restaurants and build new locations. This is pushing up the price of existing stores. Since quick-service has held up so well during the pandemic, the value of its real estate has increased, particularly to 1031 buyers who are concerned that the tax laws are going to change increasing capital gains and perhaps eliminating the Section 1031 exchange vehicle. This is increasing the cost to acquire and develop new stores further eroding the ability of smaller operators to compete.

Explain the potential of “centralized kitchens.” Why do you see this as a potential fix to some of the current roadblocks for restaurants?

Millennials like convenience. Quick-serve, while fast, is not as convenient as quick-serve plus delivery of the food to their door. GrubHub, Door Dash, Uber Eats and others all are trying to find a model to address this want.  Problem is, no one has yet found a way to make money at it.

A possible solution is “centralized kitchens.” Most of the delivery services go to a specific restaurant and pick up a specific order and deliver to a specific house. Then they do it again. Someone must pay for this service—either the restaurant or the customer or a combination of the two. The problem is that the cost of this very personalized service is expensive, too expensive for the restaurants who cannot easily pass the cost back to the customer and too expensive for the customer who does not want pay a delivery charge equal to or close to the cost of the meal.

With a centralized kitchen—which is a single location that houses multiple food concepts’ kitchens, a driver for one of the delivery services can go to one location and pick up several meals from different restaurants for different customers at the same time. This is a huge time saver for the delivery service as it allows them to make only one stop at the centralized kitchen to serve multiple customers, thus reducing the delivery cost.

Could this create unfair competition and encroachment issues for franchisees?

I would not classify it as unfair competition since anyone could open a centralized kitchen and anyone could rent space at the centralized kitchen (provided the franchisor agrees). Encroachment, that is another issue. Franchisees are very sensitive to the same restaurant concept opening too close to its existing location. If franchisors allow operators of a central kitchen location to sell to a market where there is already an established, full restaurant that is owned and operated by someone else, I guarantee there will be claims for encroachment. In addition, it is probably very feasible for a centralized kitchen to be able to service areas much broader than the usual “protected area” granted to a particular restaurant. So, a centralized kitchen could theoretically encroach on more than one operator.  I suspect this is an issue that will ultimately be resolved as franchise concepts figure out how to add this “delivery service” to its menu of options.

More broadly, what are some changes you expect to stick around after COVID? And what will separate the winners and losers?

Prior to COVID, drive-thru was about 70 percent of gross sales for quick-service. During COVID, drive-thru plus online ordering plus delivery were 100 percent of gross sales. I expect these trends to all increase over pre-COVID. Dining room traffic will continue to fall as a percentage of gross sales. The other trend that started pre-COVID and will continue is that large owner/operators will be the winners with smaller and mom and pops fading from the scene. Large operators have access to capital which allows them to obtain and buyout smaller players as well as develop new locations. This is being facilitated by the franchisors who are favoring the larger operators.

Andrew W. Lapin is a Partner with Robbins, Salomon & Patt, LTD. and has over 35 years of experience practicing in the areas of real estate, business franchise, business transactions, banking & finance, and labor & employment. His clients include entrepreneurial business owners, franchise owner/operators, real estate investors, developers and syndicators.  Andy also represents banks and other financial institutions in lending and loan workouts and restructurings; as well as in syndicated, single bank, secured, unsecured, structured finance, real estate, commercial and industrial, private bank and asset-based lending transactions.