Date published: November 16, 2011
Before the credit crisis, many dealers felt an investment in real estate was relatively riskless. Retail real estate prices had steadily increased for years. Few considered the possibility of a national decline in real estate prices.
Manufacturers told dealers if they upgraded their facilities new vehicle sales should increase. Some guaranteed increased allocations, while others provided cash incentives. Many dealers began to believe, “If we build it, they will come.”
Of course the financial markets contributed to this mentality. At the height of the credit bubble, dealers could finance 100% of their real estate projects at very attractive rates. The thought was, after building a new facility rent would go up, but so would sales. Also, real estate should continue to appreciate, so the entire investment seemed relatively riskless. How the world has changed in just a few short years!
Highly leveraged investments are by their very nature risky. Many dealers built new facilities at the top of the market, locking in very high real estate values for the long term, while securing a great deal of debt in the short term (five to seven years). Now, those large mortgages are coming due at a time when real estate values and loan-to-value rates have plummeted. Suddenly, “no money down” investments have become “show me the money” refinancings.
Real estate investments create fixed costs
Since the credit crisis, dealers have very successfully reduced variable expenses resulting in record profits. However, they have been unable to reduce their largest fixed cost, rent (see Chart 1).
According to NADA, the average dealer saw annual rent expense increase 25% between 2004 and 2009. When sales plummeted in 2009, total rent expense remained high, driving rent per new vehicle retailed to an astounding $902. Since then, new vehicle sales volumes have improved very nicely, reducing rent expense per new vehicle retailed. However, aggregate rent expense continues to climb, with 2011 tracking toward a record year and rent per new vehicle retailed still 47% higher than 2004 levels.
Unfortunately, manufacturers are once again rolling out expensive image programs after a short break during the recession. Many of these programs provide cash incentives for the dealer, but the incentives often run out while the fixed cost remains. NADA has commissioned its first ever independent study to determine the cost effectiveness of these image programs. We will all be interested in its findings.
Before that report comes out, I thought it would be helpful to provide a framework for analyzing the financial impact of an investment in dealership real estate. To do this, I looked at the sales increases required to cover the cost associated with a $1 million real estate investment, depending on real estate capitalization rates (“cap rates”) and gross profit margins.
According to our REIT sources, current capitalization rates range from a low of 8% for the strongest credit to a high of 10% for the weakest. With this in mind, a $1 million investment in real estate would result in between $80,000 and $100,000 of additional annual rent expense. The average dealership’s sales would need to increase between $533,333 and $666,667 (depending on cap rate) to cover 100% of the increased rent expense, assuming an overall dealership gross profit margin of 15%. Any sales increase above these levels would mean the real estate investment was profitable for the dealership.
Chart 2 highlights the importance of knowing from which department sales are expected to increase as a result of a real estate investment. The higher the gross profit margin, the less sales need to grow, while the lower the gross profit margin, the more sales need to grow. For instance, if a dealer only expects new car sales to improve as a result of the $1 million real estate investment, then sales would need to increase by between $1.6 million and $2 million (depending on cap rate) simply to cover the additional rent, assuming new car gross profit margins are 5%.
Image facilities’ impact on blue sky values
Dealers often ask Presidio what the impact will be on their blue sky value if they complete an image facility upgrade. If the image facility increases profits, then it will likely increase blue sky and real estate value, a win/win scenario and certainly an investment worth making (plus most buyers prefer image compliant facilities). However, it is important for a dealer to consider the downside scenario if this does not occur.
What is the impact on blue sky value if the increased rent expense reduces, rather than increases profits, meaning sales do not increase after the real estate investment is made? As can be seen in Chart 3, the more valuable a franchise the greater the loss in blue sky value if this occurs.
This analysis shows that while a dealer’s real estate may be worth an additional $1 million as a result of the investment, the dealership’s blue sky may have decreased by between $240,000 and $800,000 (depending on cap rates and blue sky multiples) as a result of the increased rent expense.
In closing, manufacturers rarely give dealers options when it comes to their real estate. Dealers are often required to build the image facility regardless of the return on investment. Also, if a dealer plans to sell his business in the near term, most buyers want image compliant facilities and will discount blue sky if a project is required. That said, it is important to understand the business ramifications of these real estate investments. Knowing exactly how much sales are needed to increase, (and from which department) is strategically important to a dealer’s business. The resulting profits or lack thereof directly impact blue sky value. An image facility is no field of dreams. If you build it, make sure you know exactly how many need to come, particularly to cover your rent factor!