For the past few years, there has been plenty of economic uncertainty impacting the franchise community. Through the various government mandated business closures, to supply chain issues, to labour shortages, every business owner has felt pressure. Now, with interest rates climbing and the geo-political conflicts persisting, how do franchisees and franchisors make planning and growth decisions?
Lets get right to the Elephant in the room. Economists dance around the specific forecasts for GDP, but many predict if we don’t fall into an outright recession, growth will still be minimal this year. A popular guess is that the country will enter into a shallow recession, calling for zero GDP growth in both Canada and the U.S. this year. However, the chances of the much talked about soft landing are rising by the day as U.S. underlying inflation declines. February’s key economic report saw the core consumer price index post a moderate rise for the third month in a row, further fuelling talk of a Goldilocks outcome in the wake of recent friendly employment report (steady job growth, moderating wages).
Will the Bank of Canada go too far?
The most widely cited risk being discussed is that policymakers would err on the side of tightening too much, rather than too little. Still, many of the country’s top economists don’t believe that the central banks have overdone it yet. Short-term interest rates are still below inflation trends, and the ongoing strength in the labour markets certainly gives no sense that rates have gone too far. More and more are suggesting the latest rate hike will be the last for the rest of 2023. And while we are addressing the Canadian economy, it is important to recognize how tied we are to our southern neighbours and the impact the Federal Reserve decisions will make. To that end, it’s a common outlook for 25-50 bp moves from the U.S. Fed at its next two meetings, and then a pause for the rest of the year. Will that be enough to tame inflation? If the central banks feel the need to do more than that, then it may be perceived as going “too far”.
How will this affect spending? Given Canada’s high household debt levels, and a large dependence on housing, we are clearly at great risk in the wake of the most aggressive rate hikes in decades. However, much stronger population growth compliments Canada’s consumer spending outlook, as does the fact that there is still more catch-up, from the restrictions of the past three years. But are we in a housing bubble? Many will say, “not any longer.” Nationally, prices are down in the double digits from last year’s frenzied high, with much deeper drops in many Ontario cities (arguably the hottest market during the pandemic). While most economists expect further declines in prices this year, as the market more fully digests the steep rise in interest rates, some have been quite optimistic on the medium-term outlook—largely due again, to the relentless strength in population growth.
And to make things more complicated, household savings have also risen to beyond pre-pandemic levels. Most will say the excess savings are homeowners likely setting aside extra funds to cover the additional annual payments come mortgage renewal time or reducing consumer debt, which ultimately don’t add anything to the economy. But those households who have debt under control with sizable savings accounts, will help keep luxury goods and leisure related retailers buoyant. By contrast, sellers of lower-end discretionary items will likely face a more cautious customer.
How does this affect franchisee financing?
March 2022 began with the interest rate increase wave that we are currently riding. House prices were soaring, and people were tapping into their home equity for additional funds aiding them for investing or potentially launching a small business. With interest rates at record lows, it was a perfect time to finance your business. Fast-forward seven months and interest rates have nearly doubled. Small business owners and franchisees who created business plans and projections based on early 2022 economic conditions, were seeing cash flow crunches as soon as the doors opened. Add to that, supply chain, labour, and meandering back-to-work policies, it immediately became a challenging environment to open and sustain a successful franchise. With no pandemic government support to rely on, the result was many franchisees were forced to dip further into their personal resources.
For a franchisee to obtain financing now, they should remember cash is still king. While we may see a slow down on interest rate increases, franchisees should account for high interest rates and cost of goods scenarios during their planning stages. This is important for a few reasons. First, the bank will sensitize financial projections to ensure the business can sustain loan payments in an economic climate with rising interest rates and consumer confidence shaken. Second, franchisees analyzing their expected performance need to plan cash flows for a conservative outcome. This makes the franchise validation process– speaking to existing franchisees to understand how they’ve weathered the past years – even more important.
While it was common for business owners to tap into their available home equity based on market valuations, banks are tightening their approach. Franchisees may now have to support house equity through appraisals as the market continues to find the balance. And not only do business owners need to enter their financing obligations with eyes wide open, but franchisors also searching for qualified franchisees should be paying closer attention to liquidity and personal leverage. More than ever, the personal financial situation will impact how the banks may be able to work with the franchisee and will also put limitations on how the banks can support the client should unexpected circumstances arise.
Small business and franchise financing has always and will continue to be centered around the strength of the borrower. Successful franchisors have consistently considered this in their valuation of a prospective franchisee. To do their part, franchisors are discussing costs and terms with suppliers to make their more brand attractive to franchise investors. Some systems are looking at ways to award franchises in non-traditional setups, express formats, and or at reduced investment levels with the financial support of the franchisor. At the start of the pandemic, necessity became the mother of all invention as business adapted on the fly to meet the changing social and economic climate. We may not be at that critical point today, but franchisors and franchisees will need to be creative to attract the most qualified candidates.
While these economic concerns create headwinds for franchisees, they are minor compared with some of the geopolitical risks the global economy may need to contend with in the years ahead. We’ve already seen how fuel, energy, and supply chain disruptions have affected the franchise community, so continued conflicts may lead to continued uncertainty.
Andrew Carter, Regional Market Leader for BMO, has been working with franchisees his entire career. His career has spanned from the Franchise side to the Finance side. His strong operational background complements his financing knowledge, providing holistic advice to all franchising situations.