Earlier this month, the Federal Reserve increased its Federal Funds rate by three quarters of a percentage point, to 1.5% to 1.75%. It was the largest such increase in nearly three decades and signals an era of rapidly increasing borrowing costs.
This must be bad news for the restaurant industry, right? The restaurant industry is in heavy growth mode. Companies are developing new prototypes at a breakneck pace. Chains like KFC and McDonald’s that hadn’t grown for years are adding locations. Everybody is selling franchises. All that requires debt to accomplish, and that debt is getting more expensive.
Maybe not. “On the list of concerns I have of the restaurant business today, I wouldn’t say rising interest rates are at the top,” said Nick Cole, head of restaurant finance for the Mitsubishi UFJ Financial Group, or MUFG.
Indeed, demand remains high for real estate for new units, and that appears unlikely to stop anytime soon. “There’s still so much demand,” said Barry Wolfe, senior managing director of investments with the real estate investment firm Marcus & Millichap. “Demand significantly exceeds supply. Interest rates would have to go up significantly to change that.”
While rates are increasing, they have yet to get to levels that would cause operators to rethink expansion plans. Many banks use SOFR data, or the Secured Overnight Financing Rate, as a benchmark rate to determine how much interest rates they charge to borrowers. Thus, in making a loan, a lender might charge a borrower 2 percentage points above that SOFR rate.
Right now, SOFR is at 1.44%. That’s double where it was before the Federal Reserve raised its Federal Funds rate, and considerably higher than the 0.05% rate that was common through 2020 and much of last year. But it remains far lower than it was before the pandemic, when SOFR was in the 2% range. Previously, lenders used LIBOR, or the London Interbank Offered Rate, as the benchmark, though that, too, was higher than the 1.44% SOFR is now.
Spreads, or the amount of interest between the SOFR rate and the rate lenders charge borrowers, have shifted to all-time lows, Cole said. Thus, he said, borrowing costs haven’t increased as much as the higher interest rates might suggest.
“People are borrowing at 3.5% to 3.75%,” Cole said. “That’s a reasonable interest rate. That’s not what we’ve seen that historically precludes investment in new store growth.”
That said, interest rates are projected to continue increasing as the Federal Reserve works to slow inflation, which remains a far bigger concern for restaurants than the cost of debt. It’s generally expected to raise rates to their highest levels since 2007. Even then, interest rates will remain historically low and cheaper than other forms of financing and unlikely to change the expansion dynamic all that much.
Federal funds rate
Source: MacroTrends.com
Consumer prices rose 8.6% annually in May, the largest such increase since December 1981. Consumers are paying higher prices for a variety of items, including gas and food—retail food costs are up 13% over the past year and full-service restaurants have raised their menu prices 9%.
The Fed’s target rate is 2%. Thus, it has some work to do to slow the increase in prices. “Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices and broader price pressures,” the Federal Reserve wrote in its announcement earlier this month.
Global events are driving much of the inflationary pressures. Continued lockdowns in China, for instance, are disrupting imports of various goods manufactured there, making it harder for restaurants to get new fryers or walk-in coolers or construction equipment on new units.
The Russian invasion of Ukraine has hit gas prices hard, taking the average price of gas above $5. That influences all kinds of costs, including the delivery of food to restaurants. It also will make it difficult for the Fed to get inflation back to its target rate. After all, Vladimir Putin doesn’t stop invading Ukraine if he has to pay 200 more basis points for financing.
But labor is the biggest problem. Companies of all kinds are still struggling to find workers. Travelers over the summer have had flights canceled in part because of a shortage of pilots as well as grounds crew. Logistics companies are increasing wages for warehouse workers and truckers over various shortages. Food processing companies have increased wages, too, helping send food costs higher.
By raising rates, the Fed hopes to slow the economy, increase unemployment and take some pressure off demand, which could bring prices down.
This is likely where the biggest impact from the Fed’s actions could come from. Rising interest rates could push the economy into a recession—with a big hand from inflation itself.
A growing number of economists now expect a recession. The Conference Board, for instance, said that U.S. economic growth will slow over the course of this year and a “shallow recession will occur in late 2022 and early 2023.” Various surveys of economists have also noted an increased likelihood of a recession over the next 12 months.
Not everybody agrees with that. Deloitte, for instance, said a recession “is less likely than some analysts will have you believe.”
“Recent recessions have not, in fact, been associated directly with Fed tightening,” it noted, noting that the 2001 recession followed the bursting of the stock market bubble, the 2007-2009 recession followed the housing crash and the 2020 recession was due to the pandemic.
Either way, a recession likely means consumers will change how they use restaurants. Some surveys have already suggested they are, with 84% saying in a Morning Consult survey that they are eating out less often. Higher prices are already impacting traffic, and there are growing indications that lower-income consumers are cutting back.
That said, the recession is not expected to be a severe one. Consumers have generally withstood an awful lot, including inflation, and continue to spend. Interest rates themselves won’t change that, though they are less likely to buy things like houses and cars where rates do play a role. “Most people don’t have a ton of personal debt right now,” Cole said. “The consumer is a little bit more shielded from interest rate increases.”
And higher interest rates could help the industry deal with the bigger problems in their growth, notably the labor shortage and supply chain headaches that have been causing delays in construction and openings. And the higher costs many companies are paying have hurt margins this year. For operators of some chains, like Burger King, it’s already led to downgrades in bond ratings.
“Other inflation is what’s hurting companies,” Cole said. “That’s what’s getting in the way of growth.”
But apparently it is only getting so much in the way. Companies like Del Taco, Schlotzsky’s, Taco Bell and Tim Hortons are developing innovative new prototypes and are looking to add them. Companies as diverse as Subway and Shake Shack and even the barbecue chain Smokey Bones are adding drive-thrus, sending costs for those locations sky-high. But demand is up for just about anything that can be turned into a restaurant. And it doesn’t appear to be slowing.
“They are much more in expansion mode than constriction,” Wolfe said. This is driving up lease costs. But operators simply pay the rent and raise prices. “So far we’ve just seen rents go up and they’ve been able to make that work,” he said.
Maybe something else changes that. But for now, it seems, the industry is growing, and if historically high inflation and the threat of a recession doesn’t stop that, then higher interest rates seem unlikely to do the trick.