Real Estate

The Impact of COVID-19 on Restaurant Landlords

Barely a month ago, restaurants, bars, coffee shops and diners were still the epicenters of social life across the United States. The threat of COVID-19 loomed larger by the day, but hope remained that a miracle would materialize and prevent a wholesale shuttering of the economy. No one among us needs reminding that that’s decidedly not how things played out.

In a matter of days in late March, as the world was rapidly educated on the severity of COVID-19 and the risks associated with groups gathering in close proximity, a combination of market behavior (eating out was among the first things that many cut back on), government suggestion (and later decree) and a sense civic duty drove thousands of establishments to shut their doors.

Though many restaurants are still allowed to offer take-out and delivery, the inability to offer a pleasant environment in which to enjoy a meal is a potentially lethal blow. While “better than nothing”, take-out and delivery is little more than a sip of water in the middle of the desert. For starters, even with certain reductions in operating costs, these orders simply cannot pick up the slack for operating at full capacity. Also, a drop-off in demand over time is almost inevitable, as customers consider both the financial impact of regularly ordering in for the entire family, and the risks of unnecessary human-to-human contact.

For some time, real estate developers have viewed restaurants as the least risky elements of shopping centers or mixed-use developments. Once seen as respites during consumers’ quests for more “stuff”, the evolving taste of the American consumer transformed restaurants into prime traffic drivers. Where malls and shopping center operators once figured that you’d grab a bite as you shopped, they now hope that you’ll visit some stores before and after your meal.

Even in the best of times, however, restaurants’ profit margins offer little room for error. The “inventory” on which they rely, fresh ingredients, is highly sensitive to demand, as anything that is not used fairly quickly is lost to spoilage. Add to this the complexity and vulnerability of their supply chains, and you’ve got a rather fragile ecosystem. In an attempt to ensure their survival in an almost-no-revenue environment, restaurants are exploring myriad cost-cutting options.

Unfortunately, as is so often the case, the industry’s labor force will be heavily impacted by both temporary and permanent closures. According to data from the National Restaurant Association, an estimated 5-7 million restaurant jobs will be lost in the U.S. in the second quarter of 2020.

However, this alone will not stave off the existential threat faced by standalone eateries and restaurant groups and companies. There is another, sizable shoe dropping on the industry: how to handle the billions of dollars in rent owed by businesses that have been forced to close? During any “traditional” economic disruption commercial real estate becomes a hot-button topic. This is not a recession the likes of which we’ve seen before. During this, an extended near-global shutdown, shrouded in uncertainty – both around timetables for the relaxation of quarantine requirements, as well as the willingness of customers to immediately pile back into crowded bars and restaurants – simply surviving is top priority.

The Cheesecake Factory, a Southern-California-based “upscale casual dining” operator, announced in late March that it would not be making rent payments on April 1 on any of its 200+ restaurant locations, citing loss of income stemming from the pandemic. At the same time, sandwich chain Subway also told landlords that it was considering cutting, or altogether withholding rent payments on its 20,000+ stores in the coming months, also as a result of coronavirus closures. Meanwhile, Darden, parent of the Olive Garden and Longhorn Steakhouse casual dining chains, paid April rent on its locations in full, but also withdrew its fiscal 2020 outlook, suspended its quarterly dividend and fully drew down a $750 million credit facility “out of an abundance of caution.”

The fear is that an already-high-stakes game of cat-and-mouse could explode into a long-running battle between restaurant operators and landlords. Should it continue, this pattern of rent deferral or withholding, combined with the long-term decline in brick-and-mortar retail –which is itself shuttered at the moment – will spell disaster for commercial landlords. Suffice it to say, the early indications from a number of commercial real estate firms and real estate investment trusts (REITs) aren’t terribly promising.

Macerich, the U.S.’s third-largest operator of shopping centers has reportedly only received about 5% of expected rent for April. The company indicated that would likely send default letters to tenants who did not pay April rent, though the efficacy of such an action, if taken, remains to be seen. Westfield, Taubman and Brookfield Properties, another trio of large retail and dining focused REITs, after reportedly receiving little of their expected April rental revenue, told tenants that they’d be required to pay in full, and similarly threatened defaults. Finally, as of the second week in April, Simon Property Group hadn’t responded publicly to tenants, though the Indianapolis-based shopping mall giant had furloughed 30% of its workforce, including at least one national restaurant leasing representatives.

As restaurants fight for their lives, many landlords face a similar struggle. They also cannot afford an extended period without revenue, as many of their developments are financed by substantial amounts of debt. As dining establishments call for reductions in rent through lease amendments and other measures, landlords are forced to reckon with their own creditors and insurers. At the time of writing, U.S. relief packages don’t directly address rents, though there is hope within the industry that the Federal Reserve may allow banks greater leeway to defer mortgage payments, allowing property owners to delay rent.

These are the struggles whose resolutions will shape the restaurant business in the short term. Though all parties are eyeing their own survival, collaborative efforts are needed to ensure the health of the industry and a return something resembling “business as usual”. For instance, in New York, restaurant (the New York City Hospitality Alliance and the NYS Latino Restaurant, Bar & Lounge Association) and real estate trade groups (landlord lobbying group Real Estate Board of New York) have come together to call on elected officials, including Governor Andrew Cuomo and Mayor Bill de Blasio, to implement their proposed “Blueprint to Save Small Business”. The proposal focuses on four key areas:

Paycheck Protection Program (PPP): Under the current federal stimulus plan, restaurants that don’t fully rehire staff by June 30 must begin repaying PPP loans sooner than those that do. At present, ~75% of funds must go toward payroll. The groups are asking that the program be amended to allow a greater chunk of loan money to be used for rent and other payments.

Sales tax: Restaurants have asked the state to cancel state tax collection for the first quarter of 2020. The state has only agreed to waive late fees for businesses that file every quarter or annually. The group is calling on the state to convert already collected taxes, and money that is due, into grants to revive ailing businesses.

Rent and mortgages: Some state legislators are working on a proposal to cancel rent for 90 days, with mortgage forgiveness for landlords. Property owners say that this isn’t enough, and are also calling for the creation of a fund to help with payments for items like building repairs and taxes.

Insurance: Some small businesses’ interruption claims have been rejected, as insurance typically only covers physical damage to shops, and has clauses about viruses that exclude coverage. Business leaders are calling for a recovery fund similar to ones created after 9/11 that would allow for these claims to be paid.

However, once these immediate-term issues are addressed, there are longer-term trends worth considering that will impact commercial real estate – restaurants in particular – for some time to come.

Epidemiological experts predict that it will probably be more than a year before vaccines are human-approved, produced in large quantities, made widely available and applied sufficiently to create herd immunity. Until that point, some regions may experience ebbs and flows in the stringency of social distancing rules. As most restaurants are already struggling to survive a two- month closure, years of intermittent social distancing will be a death knell to many eateries.

Even as social distancing is relaxed, some businesses will pivot away from the current everyone-on-site, mass-workplace model, in favor of allowing more employees to regularly work remotely. As organizations shift to “hoteling” – temporary desks (and having fewer desks overall) for workers in the office on a given day – and become more vigilant about employees not coming into the office when sick, lunch traffic at fast food and casual dining in business-centric areas will struggle to fully rebound, possibly long-term.

This will likely result in a drop in new commercial construction, as fewer businesses operate in the industry, with a sufficient number of locations already in existence. The trend is likely to shift toward cosmetic renovations, with major projects only undertaken out of necessity. It’s also likely that, more than before, the primary consideration in taking on a renovation project will be its potential for boosting operating income.

Additionally, owners of restaurant real estate that remains empty post-social distancing will look to shift toward business models better equipped to operate with minimal interruption during a major disruption. We may thus see an increase in delivery-only, or “ghost” restaurants – food establishments with no physical storefront that exist solely to prepare and deliver ready-to-food to online customers. Currently, most ghost kitchens are shared culinary spaces, often in areas with high restaurant start-up costs. Space is allocated to different companies, with access to common services, such as cleaning, maintenance and delivery. These businesses rely on automation and robotics for efficiency in ordering, inventory management and food preparation and, if executed effectively, offer the potential for increased profit margins.

It’s more obvious than ever that most restaurants operate with virtually no room for error. Expect the survivors of the current industry crisis to take aggressive steps to shift the odds in their favor.

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