Inflation & Unemployment

Inflation and unemployment are two of the most critical indicators that economists and policymakers monitor when discussing the economy’s health. Though the two are not directly related, research has shown that they do, in fact, strongly impact each other. The Phillips Curve hypothesizes this relationship between inflation and unemployment, stating that when inflation is high, unemployment is low.

Policymakers face a severe issue as a result of this relationship. While low unemployment may appear to be beneficial to the economy and people, an unemployment rate that is too low may cause inflation to rise. However, if the government takes action to reduce inflation, it may minimize unemployment and cause a recession. This inverse relationship between inflation and unemployment can affect several aspects of commercial real estate, primarily the restaurant industry.

Restaurants Affected by Inflation

Many restaurant operators entered 2022 with an eagerness to expand, but that changed when the economic landscape caused their focus to shift toward maintaining current operations. In 2023, operators are being forced to balance rapidly rising costs with maintaining consumer demand for their products.

Operators have been combating rising costs by mixing up menu prices in three ways:

• Dynamic Pricing – increasing menu prices during high traffic and decreasing them during low traffic
• Barbell Menu Pricing – increasing menu prices on the highest and lowest demanded menu items while leaving the middle items untouched
• Removal of Discount Specials and Deals

According to Restaurant Dive, over the last two quarters of 2022, full-service menu prices rose on average by 8.8%, while quick-service menu prices rose on average by 7.7%. Year-over-year menu price hikes averaged 8.4% between February 2022 and February 2023. Data from Revenue Management solutions shows that price increases beyond 10-13% had a noticeable impact on overall foot traffic. Additionally, about a third of restaurants expect their overall profits to flat line in 2023, and half anticipate a noticeable drop in income.

Understanding the Needs of Consumers During High Inflation

Inflation exceeded 7.5% in 2022 but has begun to slow in recent months. As of February 2023, the annual inflation rate for the U.S. is 6.4%, according to U.S. Labor Department. With this in mind, consumers have had to adapt to higher grocery, gas, and living expenses. These higher prices have made consumers feel the need to search for cheaper food options. More affordable food options tend to be from restaurants that offer fast service, which explains why internet searches for quick service and fast-casual concepts were up 10% in Q3 2022 compared to Q2 2022 and up 8% year-over-year.

In 2022, the worldwide fast-casual restaurant market was worth around $190B. The market is predicted to develop at an 11.5% CAGR from 2023 to 2028, reaching a value of roughly USD $365B by 2028. For the United States, the fast food industry will generate $366.9 billion in revenue in 2023. According to Restaurant Dive, during the third and fourth quarters of 2022, visits to full service restaurants were down 18.2% compared to the same time in 2019 and down 6% compared to 2021. Comparatively, quick service restaurants (QSR) saw only a 7.1% decline from 2019 during that same period and a 0.7% increase from 2021.

Year-over-year sales growth for quick service and fast casual restaurants was up 5.2% in the fourth quarter of 2022. However, year-over-year guest traffic growth has been negative for the past eight months.

If traffic isn’t driving sales growth, what is? Sales are being driven by an increase in average check size which was up to 9% in October 2022.

Average check growth does not take into account the fact that operators are raising prices. For example, if IHOP, which raised prices 11% year-over-year in October, experienced an average check growth of 9%, after adjusting for price hikes, purchase volume per check is down 2%. This difference between average check growth and YOY sales growth is most likely attributed to a decrease in consumer demand or a decrease in total volume purchased per check.

While menu prices have been increasing across the board, grocery prices have also been growing:

• On average, food-at-home prices have increased by 13.5 percent.
• On average, food-away-from-home has increased by only 8.0 percent.

This difference has allowed a steady demand for restaurants to be maintained. However, the lack of workers readily available hinders operators from being able to take full advantage of this demand growth.

Unemployment in the Restaurant Industry

As we find ourselves almost three years removed from the pandemic, the hospitality industry is still on average 500,000 employees short compared to pre-COVID levels. 81% of operators say that they are short at least one position. At the same time, servers and dishwashers (full-service positions) remain in the highest demand.

Filling open roles is not the only struggle for restaurants; retaining employees has become increasingly difficult in the full-service restaurant industry. Historically, the average turnover rate for restaurants is 23%. Recently, full-service restaurants are approaching turnover rates of up to 32%.

Restaurants are forced to operate with fewer workers, which results in a reduction in operating hours. The average U.S. restaurant is now open 6.4 hours less (7.5%) per week compared to three years ago. Casual dining chains closed on average 9.0 hours per week compared to three years ago. Most dramatically, Denny’s and IHOP reduced their hours by 30.1 and 17.1, respectively. Conversely, some quick-service restaurants, such as Wendy’s, have expanded their hours to offer additional menu items.

To combat this labor shortage, operators have begun outsourcing their labor needs to their suppliers by ordering premade foods that require less in-house labor to prepare for consumers. When operators outsource food preparation to save on labor costs, the ultimate trade-off is the quality of food delivered to consumers. How long will customers continue to pay higher prices for food of less quality and freshness?

Important Considerations For Restaurant Landlords in 2023

In 2022, inflation drove up costs across food, beverages, and labor, which has continued in 2023. Combined with continued economic instability and the need for new strategies to deal with the sector’s ongoing workforce shortages, continued viability in 2023 will require tight management and wise investments.

If you are a restaurant landlord, you should think critically about the rising risks associated with restaurant properties as investments. If a location is underperforming or not reporting sales, it is important to get the property evaluated by professionals to identify if these risks are relevant to your investment.

If nearing the end of a lease term, restaurant operators will begin to view the option periods not as an extension of their term but as another place where they can cut costs and improve their bottom line. Strong guarantees are more important than ever. As restaurant margins shrink, operators large and small will begin to start consolidating their operations into their most profitable locations.