How to cook your own goose
Harlan Goldstein, owner of prestigeous restaurant Gold, recounts a favourite tale. A boisterous group of mainland diners had come to his restaurant. He warned the Beijing-based host that a bottle of 1945 Mouton Rothschild was too expensive. Despite - or perhaps because of - the warning, the host, with his guests looking on, charged the HK$2.3 million bottle of wine to his credit card.
It was a true 'ka-ching' moment for Goldstein, and one that shows that running a restaurant has its flashes of glorious money-making. Alas, such moments are rare. This restaurant business is an extraordinarily high-risk, low-return venture, but one that nevertheless seduces smart people to invest big sums all the time.
Why is that? Many wealthy individuals in Hong Kong have been asked to invest in a restaurant. Bankers back such establishments because these deals avoid the conflict-of-interest restrictions normally found in stocks and funds.
Truly, there is potential in the business. According to government data, restaurant receipts for the first three quarters of this year totalled HK$65 billion. The increasing rise of mainland tourism has also translated into robust local demand for high-end establishments.
There is also a certain amount of glamour in the restaurant business that appeals to individuals.
Investors fantasise about owning a buzzing Central hot spot overrun with good-looking people, and where the proprietor profits from showing his excellent taste with the menu, decor and guest list.
'Every rich guy in Hong Kong wants his own restaurant to show off,' says a manager of a popular establishment.
The reality is very different. To start, few businesses in Hong Kong are as relentlessly competitive. Costs are always rising, the margins are unforgiving, and restaurant proprietors are at the mercy of rent rises that can be charitably described as extortionate.
'Rent should ideally be less than 25 per cent of sales, like in other metropolitan areas, but in Hong Kong it is more like 40 per cent,' says an insider at a major restaurant group. 'And in the casual dining segment, which describes most eateries, food cost can't be less than 25 per cent of sales if you want to maintain decent quality. Throw in 20 per cent to 35 per cent for labour and you can understand how profit margins are trapped between 5 per cent and 10 per cent.'
Profitability is often completely dependent on how much cash flies out in the form of rent, so lease arrangements generally drive an eatery's long-term survivability.
Hong Kong's landlords are notorious for dramatically raising rents with scant regard to a tenant's survival as a business. Ironically, perhaps, the large developers that own major shopping malls are actually more sympathetic to a restaurant owner's need to eke out a little profit. Mall operators want a balanced retail mix to attract shoppers to their large properties, and are willing to cut a little slack on the rent paid by a popular eatery.
Unlike landlords in North America and Europe, who are willing to enter into 20-year leases with tenants, Hong Kong restaurateurs have to make do with three-year contracts. If they are lucky, their landlord might offer a three-year lease with a two-year option, which operators say is probably the most favourable arrangement seen in today's market.
Short-term leases that result in steep rent rises on renewal dramatically increase the threat of seeing a restaurant shut down, which poses a tremendous risk for investors. The investment in costly renovations, fixtures and other fixed assets must be recovered over a relatively short, three-year term. Furthermore, all of these assets are depreciated over three years instead of, say, 20, which eats into profit.
Indeed, many managers quietly admit that most casual dining outlets are probably making meagre 5 per cent profit margins.
Investors could save themselves much trouble by buying listed stock in Cafe de Coral (341), which pays a dividend yield of about 4.8 per cent and which has very little risk of going out of business.
Developing loyal customers is a challenge. According to experienced managers, most restaurants have a three-month rush after opening. But if they cannot maintain consistency, that early surge usually dies off in six months.
This likely explains the anecdotal 90 per cent to 95 per cent failure rate for restaurants in major cities.
Does opening an outlet in a tougher economic climate when rents and other costs are lower improve the odds for success? A 2009 study by the New York State Restaurant Association finds the risk of failure is the same in good and bad times. This study was performed when some rents in prime locations had dropped by as much as 66 per cent, landlords were offering incentives to tenants and a large pool of cheaper, unemployed workers became available.
Of course, some restaurateurs, such as Goldstein's, do find success in this industry. He credits his financial backer, who he says, 'shares his passion for fine dining and supports his management vision and style'. He estimates profit margins in the fine-dining segment are between 10 per cent and 15 per cent. 'They are lower than they were five years ago when labour and rents were more reasonable. Nowadays, all costs are soaring,' he says.