Restaurant lending rises, but only for the big players

Banks are lending money at a faster pace to large restaurant franchisees, but mom-and-pop shops with an appetite to expand are still struggling to get the cash.

Loans to franchisees--a key source of funding that helped the likes of Pizza Hut and Applebee's spread nationwide--fell dramatically during the recession. "Now the credit markets are very active again. It's a depth and breadth that we haven't seen in the last few years," said Dave Farwell, head of franchise financing for RBS Citizens.

Sales are rebounding in the restaurant industry, and interest rates are at historic lows, making both bankers and restaurant operators feel like it's a good time to grow.

For instance, Border Foods Inc., a top Taco Bell franchisee with roughly 180 total restaurants, recently secured a $17 million line of credit to fund remodels, new site development or acquisitions. The loan is part of a $98 million seven-year senior credit facility.

However, veteran small franchisees are still struggling to raise enough cash just to meet the renovation demands of their parent brands, said Brad Swanson, managing director of KeyBanc's consumer & retail group.

Whether its remodeling their restaurants, like Wendy's is asking, or investing in a menu overhaul, like Burger King recently required, its a lot to ask of small businesses.

"There is a population of franchisees who got on board in the '70s and '80s when quick-serve and casual dining were really expanding, and they have a handful of units now," Mr. Swanson said. "For small franchisees like that, a $600,000 to $800,000 remodel is a significant investment."

Justin Trouard, a single-unit franchisee who opened his first restaurant earlier this year, said he was shocked at how difficult it is for small business owners to even be considered for a modest loan.

"The big banks' requirements are ridiculous. You have to have 50% of the loan in cash and 50% in collateral," he said. "At that point, you don't even really need a loan."

For a while, all he could find were offers for unsecured loans at interest rates of 15% to 20%. Mr. Trouard eventually received an offer from a local bank using an online matching service called BoeFly, and he recently opened his Dickey's Barbecue Pit franchise in the D.C. area.

The International Franchise Association says lending to franchisees in general--not just restaurants--will reach its highest level this year since the recession, lending $23.9 billion. However, there's still an expected shortfall of $2.6 billion between franchisees' appetite for growth and banks' ability to meet the demand, the association said.

"We're seeing definite improvement, but we're not out of the woods yet," said IFA President and Chief Executive Steve Caldeira. "Their already thin margins are being squeezed by things like health-care regulations and commodity costs, and it's making it extremely difficult for small business owners to turn a profit."

As a result, underperforming locations are selling out to bigger franchisees or being bought back by the parent brands, since they can afford to invest in improvements. Last week, a 40-unit Applebee's franchisee, RMH Franchise Corp., bid $8.6 million in a bankruptcy auction for 15 Applebee's locations owned by a smaller Illinois franchisee. The deal needs approval from a bankruptcy judge.

Mr. Farwell, of RBS Citizens, said the parent chains aren't sorry to see some of the smaller players exit, as they prefer to have more professional franchisees that tend to uphold brand standards better.

"It takes a higher level of sophistication to run these chains than it did a few years ago, so I think the consolidation will continue," he said.

Krispy Kreme Doughnuts Inc. (KKD), which is returning to new-store growth in the U.S. after a decade-long lull, said it's looking for multi-brand, experienced franchisees to lead its expansion. "You still may see some smaller players, but we're looking more for people with more flags in their hat," said Chief Financial Officer Doug Muir.

However, other brands, like Subway, whose sandwich shops are all franchised, still see an opportunity among new and smaller operators.

Subway tends to attract smaller franchisees since its menu is relatively simple and it requires less capital to open a store. They are even helping franchisees expand. "In 2008, lending tightened up, and it got harder to get access to capital," Chief Development Officer Donald Fertman said.

To help, Subway began hosting forums for potential lenders, to instill confidence in the brand. "We just held another one recently, and I think it's helped our franchisees have more success at continuing development than other chains," he said.

The chain even surpassed McDonald's in the number of locations it has, now boasting 39,500 worldwide compared to McDonald's "more than 34,000."