A HOT MARKET FOR MAKEOVERS

Bob Krummert

We carry no brief for the Franchise Finance division of GE Capital Solutions. But when this company turned six brainiacs loose on the restaurant industry to compile its 2007 Chain Industry Restaurant Review, the result was a quantitative profile of all segments of the industry that provides a perspective like no other.

To be sure, GE Capital has a vested interest here—it’s trying to convince you to borrow its money. But you can’t argue with many of the conclusions reached in its review, particularly the ones about capital expenditures and the kind of return you can expect if you make one.

Restaurant refurbishments come in all shapes and sizes, ranging from some minor touch-up work on the low end to the all-inclusive approach known in the industry as the “scrape-and-build.” The cost is more than simple repair and maintenance work (figure you’ll spend two percent of revenue per year on that), with the sky being the limit. Operators expect, of course, that their upfront investment will pay off in increased sales.

Industrywide, capital expenditures in 2007 are forecast to be roughly the same as they were in 2006. In full service, 60 percent of casual dining operators, 52 percent of fine dining operators and 51 percent of family restaurant operators told GE analysts they were planning on expanding, remodeling or buying new equipment during the first half of this year.

On average, according to GE Capital, casual dining restaurants spend $200,625 per remodel, while family restaurants spend $122,813. Despite their smaller investment, family restaurants get a bigger bang for their buck; remodeled units boost sales by an average of 5.8 percent. Casual dining operators who remodel typically experience only a two percent sales gain.

Two percent? Why go through all the expense and hassle of a remodel to make a lousy two percent?

There are a a couple of reasons why doing so might make sense.

One is that you might boost sales by more than two percent. If, for example, a casual dining operation that was doing $2.5 million in sales spent $200,000 on a remodel and then recorded a seven percent increase in sales, the return on investment (ROI) over the life of a seven-year loan would be 113.9 percent. Even if the restaurant saw sales jump just four percent, the ROI still projects out to 22.2 percent. These are big returns in the restaurant industry, especially because sales growth of 4-7 percent is a such a modest target.

Of note, a four percent sales boost on a $156,000 remodel of a QSR doing $1 million in sales results in a -37.3 percent return for the unlucky operator. This QSR unit would have to post a seven percent increase just to achieve positive ROI.

A second reason to remodel relates to keeping up with the competition. As the study’s authors note, “Historically, franchise agreements stipulated remodeling on average every seven years, but current trends show an increase of non-specified terms between remodels, creating an opportunity for franchisors to require remodeling more frequently.” In other words, the stakes have been raised on the remodeling front of late.

Whether you own your restaurant’s location or lease it will, of course, factor mightily into any decision to revamp your operation. However, the GE study notes that site acquisitions have become problematic in certain markets. In some areas, the authors note, aggressive expansion by some chains means that “prices may continue to increase as demand for locations exceeds availability.”

The message here is that if you already have a good location, staying put and refurbishing your unit instead might be the smart way to go, particularly if you can get your capital expenditures onto the books in 2007 and depreciate them more than twice as fast as you otherwise could. This may not be the perfect time to redo all or part of your restaurant, but it’s looking like the strategic time to make such a move.