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Motion and Commotion – The Buy/Sell Market Intensifies

Buy/sell activity continued its robust pace through the first nine months of 2017, tracking towards the fourth consecutive year of over 200 annual transactions.  While that indicates continuity, we are observing some significant changes in perspective that are stirring the auto retail transaction market.

I’ll provide an overview of two specific trends that we see impacting the current buy/sell market, with implications for years to come.

The Evolution of the Dealership Business Model Drives More Sellers to Market

Dealers are faced with a more challenging retail environment as sales plateau, expenses rise and new vehicle gross margins decline. Average dealership expenses hit record levels for the first half of 2017, as did dealership employment levels.  Rising expenses are driven by increasing facility, administrative and employment costs, ultimately leading to lower profits.

Chart I Average Dealership SG&A Expenses as a Percentage of Gross Profit versus Average New Vehicle Gross Margins
2011 – 2017 YTD
Source: NADA and Kerrigan Advisors Analysis

In this challenging retail environment, dealers are increasingly sensitive to dramatic headlines calling for the end of auto retail as we know it.  Comments from industry luminaries, such as Bob Lutz and Dale Pollak, are certainly alarming. Dealers without a clear succession plan or those who worry about the next generation’s ability to navigate a more complex retail environment are particularly concerned about their businesses thriving in the next chapter of auto retail.

“For dealers, a realistic view of what the world will look like has got to be part of the discussion…the next several years probably aren’t going to be comparable to the last several. Back that with the transformational stuff and you could argue that a dealership is never going to be worth more than it is today.”

Dale Pollak, Founder of vAuto and Executive Vice President at Cox Automotive Automotive News, November 6, 2017

More so than in the past, our clients increasingly cite the risk factors associated with changes in auto retail as a major driver of the decision to sell.  While we have all heard about industry disruption from many sources outside of auto retail, including technologists and start-ups, we are now participating in active discussions inside our industry about these very same issues.  

Increasingly, dealers believe the industry will consolidate out of necessity, as only the largest, best-capitalized players will have the balance sheet to navigate auto retail’s evolution. And, the benefits of consolidation are quite evident in some cost lines.  The average private dealership’s sales, general and administrative expenses (SG&A) consume 87.8% of gross profit, which is 13.5% higher than the average public (see Chart II). Economies of scale and scope will become even more important in a sales plateau where profit growth depends on operational efficiencies.

Chart II Average Dealership SG&A Expenses as a Percentage of Gross Profit Publics versus Average Private Dealer
2017 YTD
Source: NADA, Kerrigan Advisors Analysis, and SEC Filings

In this environment, going it alone looks increasingly risky and less appealing to some dealers, prompting more to sell.  We expect this trend to continue until we have greater clarity regarding auto retail’s future and the impact of the disruptive technologies creating current headlines.

“With everything going on in the automotive business today, you need to be super aggressive, have as much scale as possible and be an efficient retailer of automobiles…To do that, you need a lot of capital and a lot of size.”David Rosenberg, CEO and President, Prime Auto Group Discussing his decision to partner with GPB Capital Automotive News, October 23, 2017

Dealers Are Choosing to Sell their Real Estate with Their Franchise

In a buy/sell, sellers have often preferred to retain their dealership real estate and lease the property to a buyer, usually on long-term basis.  The rental income served as income post-transaction and the real estate asset was viewed as an attractive investment for a dealer’s estate or retirement.
We see dealers increasingly reconsidering this strategy in today’s buy/sell market.  We believe there are several important reasons for this shift.  First, dealership real estate values are currently trading at record levels, prompting more dealers to cash in on these high values. The differences in valuation multiples between real estate and franchises explains the attraction of a real estate sale.  Kerrigan Advisors estimates dealership real estate is valued at a multiple three times higher than the average dealership blue sky multiple (see Charts III and IV). In an environment where blue sky values are on the decline, rising real estate values often offset that decline and make the transaction work for a seller.

Chart III Estimated Average Dealership Real Estate Value as a Multiple of Average Dealership Rent
2017 LTM
Source: NADA and Kerrigan Advisors Analysis
Note: Average real estate value is based on a 7% cap rate of average dealership rent.
Chart IV Estimated Average Dealership Blue Sky Value as a Multiple of Average Dealership Earnings (Pre-Tax)
2017 LTM
Source: NADA and Kerrigan Advisors Analysis

The second reason we are seeing dealers choose to sell their real estate is that they are observing real estate challenges in other segments of retail.  A growing number of retail outlets are vacant today in major retail markets (see Chart V). These vacancies are a result of consumers’ shift toward online shopping. Given that most dealership properties are located on prime retail real estate, an increasing number of vacant retail properties could eventually put pressure on all retail real estate values, ultimately leading to a decline in price.

Chart V Major U.S. Retail Store Closings Announced
2017 YTD
Source: Fung Global Retail and Technology
* Closing all 134 retail stores and 34 outlet stores
** Closing 115 Kmart and 45 Sears Stores
*** Part of 100-store closure announcement made in 2016
**** Closing remaining stores included in the 50-store closure plan announced in June 2016

Concern over rising interest rates is yet another reason dealers are considering a sale of their properties.  Leases are valued much like a bond. When interest rates rise, the value of a seller’s lease income stream declines. Chart VI demonstrates that for each 1% increase in cap rate, the average dealership real estate value would typically decline ~10% on average. Also, if a property needs to be refinanced, the seller may experience a reduction in income if mortgage rates rise.

Chart VI
Estimated Average Dealership Real Estate Values at Differing Cap Rates
Source: NADA and Kerrigan Advisors Analysis

Finally, dealers are concerned about the single purpose nature of their real estate. Single purpose properties are inherently riskier real estate investments. Not only are dealership properties single purpose, they are built for a specific franchise. The conversion from one franchise to another usually costs millions of dollars.  Rather than retaining dealership properties, sellers are increasingly choosing to sell their real estate and 1031 exchange into lower risk real estate investments. An exchange usually allows the seller to maintain their tax basis and avoid the payment of capital gains taxes, minimizing the tax consequences of a sale.

While sellers are increasingly choosing to sell their real estate, buyers are often eager to acquire it. This is in large part due to today’s low interest rate environment and attractive mortgage financing terms. Buyers also appreciate owning real estate, primarily to facilitate financing when the inevitable OEM image upgrade is required. If a buyer does not wish to acquire dealership real estate, a REIT, such as Capital Automotive REIT, is often eager to step into the buyer’s shoes.

So, to sum it all up, the buy/sell market remains as active as ever, with perhaps a bit more motivation on the part of sellers who are stressed about the imminent future of auto retail.  And, given those changes, more dealers seem inclined today to exit both their business and their real estate at the same time.

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