Public and private-equity-funded companies have been building restaurants at a significant rate to penetrate new markets and achieve regional dominance. While such growth powers valuation models and compensates for lagging traffic in existing units, new unit construction also wreaks havoc on returns, insists Vancouver, Wash.-based investor and financial strategist Jim Parish.

Explain your new warning for restaurant operators.

Returns on new restaurant construction are miserable and getting worse as measured in historical terms. It's so bad that a level of return on investment that would cause rejection of a new restaurant construction project just a short while ago is now significantly above what many such new projects will produce.

Why have returns on newly constructed restaurant units collapsed?

Costs of new construction have been rising at a double-digit rate for years, and the demands on construction materials such as lumber, concrete and steel brought about by hurricane relief have merely exacerbated the trend. Plus, real-estate costs have risen nearly across the board. In addition, landlords have repackaged developments into lifestyle formats to increase per-square-foot yields and more efficiently cover maintenance expenses. The result has been higher rent per square foot for tenants.

Municipalities have reduced development staffs in response to budgetary pressures. As a result, planning, zoning and site-approval processes are stretching longer and become more costly. In many areas, municipal and neighborhood activism has resulted in harsher architectural restrictions, further adding to cost and delay. For similar reasons, infrastructure costs which used to be borne by the municipality for streets, curbing, and water and waste disposal have been transferred to developers, who typically pass them along to tenants.

In the end, what's the danger for companies?

In many cases, building a new restaurant not only doesn't add value, it may destroy it due to excess capital usage and substandard returns. A chief financial officer recently told me his company's ROI on new construction has been halved in the past 10 years, from the high 20 percent range to below 15 percent. No. 1 on my personal list of fundamental metrics to create value in restaurants is that unit-level economics must provide a superior return, on sales and on investment. Both numbers should be above 20 percent.

Are there options?

There is a viable option to new construction: the conversion of existing restaurant sites. Such sites are preferable to non-restaurant retail given that hoods, ventilation and grease-disposal systems are still in place. Yet some non-restaurant “alternative” sites should also be considered. Due diligence is critical because unseen structural concerns are always a risk.

What are the advantages?

An existing building could mean significant savings in construction costs and higher ROIs. A further advantage is that location and traffic issues are known, giving you greater certainty of the level of performance. The opportunity to obtain a quality restaurant location at a price that both enhances performance and improves ROI may be just what new investors need to bring new capital to the restaurant industry.