Exploring Dark Kitchens; an Early-Stage Investment Class?

What is the concept?

The concept of a “Dark Kitchen” - a restaurant with no physical dine-in experience, instead the kitchen produces products for delivery only – is a relatively new one. It has grown quickly on the back of increased consumer demand, particularly during the Covid-19 pandemic, and the industry could be worth one trillion dollars by 2030. At the current UK growth rate, you could order from a new place every night for the next 57 years!

The Dark Kitchen business model attracts tenants by providing an alternative option to a traditional high-street restaurant space, being more efficient, incurring lower overheads and often located in densely populated areas usually outside of their main facility, from which they can service their delivery customers.

What is the opportunity for investors?

There are several attractive economic fundamentals associated with Dark Kitchens that have spurred the sector’s significant growth, particularly over the past few years.

Occupiers see lower costs than a traditional high-street restaurant, including lower overall rents, cheaper fit-out, start-up and staff costs, and a smaller business rates burden. They also take on less risk, only signing a short-term lease or license. It is a model that tends to attract a high proportion of start-ups and subsequently covenant strength is often limited.

By purchasing a Dark Kitchen, an investor can tap into an industry that has demonstrated the propensity for rapid growth. While they take on risk around the tenant’s staying power, they can diversify that out somewhat by operating at a high site density. Whilst the sector looks like an opportunity to upside capture from new ways of living there remain several unknowns, particularly about how the sector will perform when economic conditions change.

This is particularly pertinent at the moment as higher food production and energy costs present an obstacle to the profitability of the tenant and thereby impact on the security of the cash flows of the operator.

Indeed, the link between the operating model and underlying property is fundamental. The real estate that Dark Kitchens occupy is often former industrial or office space that has been re-positioned and requires a large amount of capital expenditure to convert the space into modern kitchens. In some cases, the initial outlay is equal to the value of the property given the specialist equipment in place. Consequently, this requires levels of operational experience and skill to manage the business and ensure good levels of profitability and return on investment. It also ultimately requires a good understanding of the underlying real estate and its potential fall-back value in the case of business failure. As a result, it is often advantageous for operators to acquire real estate, rather than lease space due to potentially onerous reinstatement costs at the end of a lease term.

What is the outlook?

Having witnessed significant growth during the pandemic, major players have reported huge growth; Uber Eats has reported a 103% year-on-year revenue increase since 2020. However, it is yet to be seen whether customer demand for delivery food is sustainable in the long-term. Current trends suggest that the sector is here to stay, as restaurants look to leverage the multi-channel revenue opportunity to tap into new customers. It is estimated that there were c.1,000,000 orders on fast food apps in 2021. Nevertheless, current economic conditions will test the resiliency of the sector with the best performing operators and investors alike being those that are able to ensure efficient running of operations, whilst maintaining secure underlying cash flows.