Ghost kitchens and delivery-only restaurants may be too popular for their own good – CNBC

It’s time for a reality check.

The coronavirus pandemic accelerated the adoption of ghost kitchens and the creation of virtual brands. Both were seen as potential fixes for restaurants caught in a highly unusual predicament. Some eateries were coping with surging delivery orders, while others were looking a lifeline as government restrictions clamped down on dining capacity and slashed sales. But these once-creative solutions have been replicated too many times, at times, diluting their effectiveness.

Ghost kitchens, which are also known as cloud or dark kitchens, allow restaurants to prepare food solely for delivery. This can be critical for businesses seeing strong demand as consumers’ appetite for food delivery grows. Third-party food delivery sales grew 138% in December, according to analytics firm Second Measure.

Start-ups like Kitchen United or Travis Kalanick’s CloudKitchens house multiple restaurant brands within one location and tout their models as more efficient, lowering labor and rent costs for eateries.

Meanwhile, virtual restaurant brands are found only on third-party delivery apps, relying on those platforms for marketing rather than a physical storefront. Food from these brands is made either in a traditional restaurant kitchen or in a dark kitchen. For some struggling or failing restaurants, virtual brands have turned out to be lifesaver.

After Otto’s Tacos, a Manhattan fast-casual chain with four locations, permanently shuttered all of its storefronts in December, it approached a fellow Manhattan-based chain, Mighty Quinn’s Barbeque. The two companies opened their flagship locations in the East Village neighborhood two blocks away from each other less than a decade ago, and their founders were friendly, swapping industry updates and tips, particularly as the coronavirus pandemic hammered New York City.

But rather buying Otto’s Tacos outright, Mighty Quinn’s struck a deal instead to license the brand and bring it back to life as a virtual brand. The barbeque chain also sells chicken wings under the virtual brand Sugar Wing.  

“We decided, rather than bringing on additional kitchen capacity, to utilize what we already had at Mighty Quinn’s to execute their menus,” said Mighty Quinn’s co-founder Micha Magid.

Magid said that the company had toyed with the idea of launching a virtual brand before the pandemic. A brand that targeted the top three delivery categories – burgers, pizza or Mexican – were the most attractive, but Mighty Quinn’s lacked pizza ovens or grill tops, making Mexican food the most sensible choice, according to Magid. Otto’s also came with tens of thousands of social media followers, a level of trust from consumers who had eaten inside its restaurants before and a higher percentage of delivery customers even before the crisis.

But for Otto’s and Mighty Quinn’s, the winning element of the formula might just be the personal relationship and trust between the two companies. Magid said that he didn’t think that the model would work for other struggling restaurants.

In June, Chili’s owner Brinker International started a virtual brand called It’s Just Wings. The delivery-only brand’s food is made in Chili’s kitchens and sent out by third-party delivery companies. Brinker has said that the chicken brand is generating sales at a rate of $150 million per year.

But every success story seems to generate a new wave of copycats. Applebee’s and Bloomin’ Brands are among the full-service restaurant chains that have decided to step into the arena and create their own virtual brand that serves chicken wings.

“You can’t keep just throwing up virtual brands – at some point, there’s saturation,” said Dan Fleischmann, vice president of Kitchen Fund, a venture capital firm that focuses on the restaurant industry.

Despite running two virtual brands, Magid echoed the sentiment.

“What I think what’s honestly happening now that will be different this time next year is that there’s honestly too many virtual brands popping up that are based on nothing more than a menu that seems to be on trend and some pictures,” Magid said.

Ghost kitchens are seeing similar trends. New companies, like Trolley Eats, seem to pop up every week, along with announcements from the likes of Famous Dave’s and Fat Brands that they’re leasing a dark kitchen.

“From what I’m hearing, the demand for those [ghost kitchens] is skyrocketing, and so are the prices,” BTIG analyst Peter Saleh said at the virtual ICR conference in January.

Saleh told attendees that he spoke with a restaurant operator who said he would pay the same amount for a 200-square-foot space in a ghost kitchen as a 3,000-square-foot restaurant in the same market.

Fleischmann, who was skeptical of ghost kitchens even before the pandemic boom, said that he doesn’t think that most restaurants will be able to make the economics of a ghost kitchen work.

“It’s still such a low-margin business to begin with, the owner taking 30% out and then having to go through an aggregator like DoorDash or UberEats is really difficult,” Fleischmann said.

With every order placed on a third-party delivery app, restaurants pay a commission fee to the platform. These charges range from 15% to 30% of the order total, although some U.S. cities have placed fee caps on delivery companies during the pandemic to aid restaurants.

Bartaco CEO and founder Scott Lawton said that the chain has opened two ghost kitchens to relieve some pressure from its own kitchens when it comes to preparing its takeout orders. While one location is in a multibrand ghost kitchen, the other is the result of an agreement with another restaurant that shuttered temporarily. Lawton said that the multibrand ghost kitchen has more costs associated with it.

“At this point, there’s too many hands in my pocket there, and I don’t really understand how people make money doing that,” he said.

C3, a food hall and virtual kitchen subsidiary of hospitality company SBE Entertainment Group, finished 2020 with nearly 200 kitchens and 15 virtual brands less than a year after its launch, according to SBE CEO Sam Nazarian. It’s committed to opening more than 400 new kitchens this year so far. Its growth is largely thanks to the consortium that created C3: SBE, hotelier Accor and mall owner Simon Property.

“We feel that the opportunity to take advantage of the real estate environment and to be aggressive as far as tenancy around the country and the world is what is a differentiator for us right now,” Nazarian said.

Analysts are forecasting that some trends will bolster ghost kitchens’ future prospects. In a note looking ahead to the next five to 10 years for the restaurant industry, Bank of America analyst Gregory Francfort wrote that dark kitchens will struggle to compete with casual dining’s unused kitchen capacity.

“But an emerging ghost kitchen concept will partner with one of the biggest aggregators, unlocking rapid consumer brand visibility, creating a successful model,” he added.

Saleh wrote in a note to clients that President Joe Biden’s $15 wage proposal could aid in the adoption of ghost kitchens, which have fewer workers than a traditional restaurant.

But as vaccines are distributed across the U.S., food-delivery sales are expected to stabilize. While the crisis has introduced many consumers to Grubhub or Postmates for the first time, they will also likely want to return to dining in-person at some point. Falling demand could mean fewer tenants for ghost kitchen companies and orders for food from virtual brands.

“I think when the pandemic is over, a lot of these restaurants will come off the delivery apps,” Nazarian said. “The virtual brands will not make it … they’re not true operators.”

C3 is betting that consumers who grew to love its virtual brands like Krispy Rice and Sam’s Crispy Chicken will want to visit the company’s food halls that will soon host physical locations of those same brands. C3 signed licensing deals with about 50 airports last year, according to Nazarian.

“I kind of equate it back to the dotcom era when everybody had a website. Some of the websites worked, some didn’t,” Nazarian said.