How federal interest rates are affecting restaurants.
By Daniel McCoy
The recent rise in interest rates is having a significant impact on the hospitality industry, and many restaurants are feeling the effects.
For years, restaurants have relied on cheap loans to fuel growth, but as rates climb, many are finding it difficult to keep up with their debt payments.
Can you imagine the interest on your debt more than doubling in 7 months? Well, it has happened.
The Federal Funds Rate is the rate banks charge one another for overnight lending. The prime rate is set 3 percentage points above that, so if the fed fund rate is .25%, then the prime is 3.25%. This is the rate the top customers get from the banks. Most banks lend on a Prime +% basis, line Prime +1 or 2%.
The Federal Reserve uses the Prime Rate to slow or accelerate lending, theoretically. If you are offered a rate as low as 3.25% (cheap money) versus 7.50%, you are more likely to borrow money.
So when the Fed rate was lowered to .25% and Prime at 3.25% in March 2020, it was intended to incentivize borrowers to borrow money during the pandemic. The Prime remained at 3.25% until May 2022, when the Fed took action to start slowing down the economy and reigning in inflation by raising the Fed rate, thus also raising Prime.
The Federal Reserve, in order to combat inflation, began raising rates. So by December 2022, just 7 months later, Prime rested at 7.50%, well more than double the rate in the beginning of May.
One of the most significant impacts of rising interest rates is on restaurants’ bottom line. As rates go up, the cost of borrowing increases, making it more expensive for restaurants to access capital. This can lead to higher debt payments, which eat into profits and make it difficult to reinvest in the business.
Also, many restaurateurs took advantage of the cheap money when it was available. However, as is common practice on many commercial loans, the rate was a variable or adjustable rate, meaning every time that Prime went up, their rate increased as well.
In my years of lending, we often would do a “Shock Rate” using a rate much higher than the current rate to make sure the client could afford the loan if rates did increase. However, typically we would shock by 2 basis points, not more than double the rate.
Certainly, if you have been in business for a couple of years and generating good cash flow, there are lenders that will move you to a commercial loan with a fixed rate.
If your current loan is an SBA-guaranteed loan, one issue is the term of commercial loans are much shorter. For instance, with equipment or furniture and fixtures, an SBA-guaranteed loan can go out 10 years vs. a commercial loan having a term of 5 years; meaning you have higher payments to pay the loan off in a shorter time.
If there is real estate involved, you might refinance using the SBA 504 program, which offers a fixed rate on the SBA side for up to 25 years and usually a matching fixed rate for 10 to 15 years on the bank side. However, watch out for prepayment penalties and what happens if the rates drop again below the fixed rates the 504 offers.
Another way that rising interest rates are affecting restaurants is by making it more challenging to attract investors. As rates go up, investors look for higher returns, which means that restaurants may have to offer more significant equity stakes or higher interest rates to secure funding.
Investors today want a more secure place to put their money with the stock market acting erratic. However, they are looking for more significant financial incentives. This can make it challenging for smaller restaurants to compete with larger chains and can limit their ability to grow.
Rising interest rates are also affecting consumers’ disposable income, thus their ability to dine out often. A rising prime rate affects things like credit card rates, home equity rates, car loans and (indirectly) mortgages. As the cost of borrowing goes up, credit becomes more expensive, making it more difficult for consumers to afford the necessities of food and shelter and pay existing bills.
At the same time, many incentives offered because of the pandemic are expiring without anything to replace them. This may lead to a decline in sales and may force some restaurants to close their doors. It certainly can make the restaurateur have second thoughts about opening or expanding to a new location.
Despite these challenges, many restaurants are finding ways to adapt to the changing environment. Some are focusing on cost-cutting measures, such as reducing staff or renegotiating leases, while others are exploring new revenue streams, such as catering or delivery services. While delivery services cut into the bottom line, it can also reduce the need for extra waitstaff and runners.
Finally, rising interest rates are having a significant impact on all industries, not just the restaurant industry, and many are feeling the effects. However, restauranteurs that are initiative-taking in adapting to the changing environment may be able to weather the storm and emerge stronger overall.
For those still committed to growing their business and the industry there are several opportunities where restaurants closed in the pandemic and left a void in the area.
The good news is the prime rate will always change again. Plan ahead and you’ll be ready for the next time rates shift down.
Daniel McCoy joined the UGA Small Business Development Center at KennesawState University as a business consultant 2017, after a 21-year successful banking career as a Commercial/SBA Lender and Financial Adviser and 10+ years in upper management in the retail industry. He is a Certified Professional for the Society for Human Resource Management (SHRM), a member of the National Society of Leadership and Success and recently completed the Veteran At Work Certification process. He is also a 2019 Flewellen Award for Consulting Excellence winner. For more on how the UGA Small Business Development Center can help your concept, go to georgiasbdc.org or contact Daniel at dmccoy@georgiasbdc.org.
