Franchise Development and Economic Uncertainty

Posted on May 23, 2023 in Blog

The prevailing legend of the “recession-proof” franchise hasn’t faced the anticipated test of 2023 – yet. Historically, franchises have weathered economic storms well, relying on economies of scale and pooled resources that sole proprietorships can’t access. With inflation elevated and commercial lending rates high, how has franchise development been faring? How will it change?

As a leading franchise development marketing agency, we take pride in regularly taking the pulse of the franchising world.

The State of Franchise Development

The franchise model remains an important component of the US economic engine. According to forecasts from the International Franchise Association, franchise companies are experiencing healthy growth despite several economic barriers.

Franchise operations are expected to add 254,000 jobs by the end of 2023 to reach a total of 8.7 million. Many of those jobs will support the additional 15,000 new franchise units opened during the year. The report states franchises will contribute more than $521 billion to the US’s GDP.

The Post-pandemic Normal

How did the pandemic affect the franchising industry, and where are we now? Franchising has largely recovered from the earliest days of the COVID-19 pandemic. State-mandated closures and shrinking demand in some sectors caused thousands of franchise locations to close in 2022, reducing the total number of franchise units by 2.6%.

Several markets were more severely impacted during that time, with restaurants (-6.6%), personal care (-7.4%) and business services (-4.9%) experiencing the most closures.

Recovery from these losses has been swift, but it’s uncertain how long this will last – more about this below.

Areas with the Fastest Franchise Business Growth

The pandemic caused historic population shifts, which are mirrored by regional growth in franchising. Three of the top ten states with the most inbound migration are represented in the top ten fastest-growing parts of the US for franchise development:

Texas
Illinois
Florida
Georgia
Tennessee
North Carolina
South Carolina
Arizona
Colorado
Indiana

Illinois is positioned as a prime opportunity for franchise operators, having increased total franchise revenue by 7.9% and employment by 6.6%in 2022 (both national bests).

Economic Realities Rock Franchise Development

The first quarter of 2023 roiled markets with considerable financial uncertainty. Tech-heavy lender Silicon Valley Bank collapsed in March, with immediate ripple effects. Signature Bank collapsed just 10 days later; its assets were eventually scooped up by New York Community Bank. JP Morgan Chase picked up the pieces of First Republic Bank on May 1.

Interest Rates Crash Bond-Heavy Banks

Financial institutional failure is often a sign of mismanagement, but rapidly rising interest rates contributed to the problem. Substantial investment in “safe” treasuries, many yielding below 2%, put banks like SVB billions underwater in 2022 when yields tipped above 3%. These mid-sized, regional banks are crucial funding sources for small businesses. Total deposit outflows in regional banks ranged from 1.2% to 17.2% in the first half of the year, limiting the financing power of these institutions.

How Have Commercial Lending Rates Affected Franchise Funding?

Franchise funding is heavily reliant on commercial lending in the form of a small business loan. Funding facilitates buying and opening a new franchise and provides liquidity to support capital investments in equipment, software or other assets.

Rising interest rates have affected franchise funding – and, therefore, franchise development – in several major ways:

Fewer Attractive Franchise Financing Options

After more than a decade of low interest rates, many lenders have tightened standards and increased interest rates. Today’s financial institutions are better capitalized than their 2008 predecessors and predisposed to limit exposure when the economic climate gets murky – which is exactly what has happened.

Commercial Lending Gets Strict

Private bank loans remain the most competitive, in terms of interest rates, though conventional loan rates have climbed steadily since January 2022. The 2022-2023 average conventional business loan rate is 5.5%, with Q2 2022 rates over 6%.

Most lenders have tightened lending in the past months: Consistent themes are increased credit standards, higher capital requirements and prerequisites for extended business history. For franchises, this has raised barriers for first-time franchise investors, especially those without several years of books to use during the application process.

Interest rate: 6.3%
Repayment periods: 3, 5, 7, 10 years

SBA Loans (7A and CDC/504)

The Small Business Administration’s (SBA) loan program is provided by qualifying private lenders. In most cases, SBA loans have higher interest rates but longer repayment terms.

SBA 7A – 7A loans can be used for any business expense, including buying a franchise license and starting a business. As a result, 7A interest rates and applications are the most helpful indicators of fran-dev activity.

Since 2021, SBA 7A interest rates have nearly tripled, from a 2.69% 25-year-term rate in January 2021 to 6.03% in May 2023. Over the life of the loan, that’s a 153.01% increase in interest paid.

SBA CDC/504 – CDC or 504 loans can only fund capital investments in real estate, equipment or machinery. Many 504 loans are joint-funded; a private lender and the SBA each contribute 50% of the loan amount.

Both types of SBA loans are typically for 25-year terms.

How Are SBA Loans Affecting Franchises?

Live Oak Bank is a franchise-focused lender that releases industry data on SBA loans quarterly. In Q1 2023, the highest volume of SBA loans was focused entirely on restaurant and quick restaurant franchises (e.g., coffee shops and drive-thru locations), reflecting a wider consumer trend of shying away from big-ticket purchases and leaning toward food and lifestyle spending.

Is It a Good Idea to Buy a Franchise Right Now?

The outlook is mildly optimistic. Franchise developers and investors may look forward to anticipated growth in most franchise markets. With total franchise units expected to grow 1.9% in 2023, a few markets should exceed the mean.

These franchise sectors have the highest projected growth:

Personal services: 2.5%
Quick-service restaurants: 2.5%
Commercial and residential services: 2.1%

These franchise sectors have the slowest growth or most projected decline:

Full-service restaurants: 1.1%
Lodging: 0.8%
Real estate: -0.5%

The Macroeconomic Picture

Certain industries face increased exposure to broader economic risks. The federal funds rate is expected to stay over 5% in 2023, contributing to increased unemployment and a general economic downturn. The anti-inflationary stance of the Federal Reserve and current administration makes additional household or commercial stimulus unlikely, and SBA loan amounts are expected to decrease from 2022 levels.

The Labor Debate

A strong labor market has increased labor costs across the economy. 85% of surveyed franchisors have increased wages to attract or retain workers. 87% of franchised businesses have struggled to hire enough workers to meet demand or maintain normal operations.

Labor, volatile energy prices and lingering supply chain issues are expected to impact franchise business and the wider economy throughout 2023.

Franchise Development: A Prediction

Franchisors should evaluate their in-house capitalization to provide short-term loans to prospective franchisees with excellent credit and a solid financial history. If the economy does enter a recession in 2023, franchises can capture market share by doubling down on marketing efforts in key regional markets. We anticipate total franchise output to exceed the IFA’s 2023 projection of $860.1 billion but fall short of its unit and employment growth.

We Love Talking Franchising

Oneupweb is a leading franchise marketing agency with more than two decades of institutional expertise. With an integrated team of designers, writers, developers and strategists, we’ve helped franchisors access new markets and provide value for their franchisees. See what we can do! Contact us here or call 231-922-9977 to get started.