By James Mitchell, Cushman & Wakefield
We’ve explored the importance of valuing your real estate (see “Why Aren’t We Talking More About Real Estate?” Buy Sell Report, March 2019), and how to get it appraised (see “Approaches to obtaining a good real estate valuation” Buy Sell Report, May 2019). The next step is to decide how much rent the dealership should pay.
You might think it’s best to charge your dealership a below market rent. Lower rent means higher net income and therefore a larger blue sky. But this is not the case. In determining blue, a buyer is going to adjust the rent to an estimate of the market level to isolate the dealership’s true profitability. How should you proceed?
An acceptable rental expense is derived from what is called a market capitalization rate (“cap rate”) which is the annual percent return required by an owner of the real estate to cover the cost of borrowing, plus a profit.
For example, if you have a mortgage on your property, a bank will charge you an interest rate based on some benchmark, such as the 10-year US Treasury – currently about 2.00% – plus a spread, which typically ranges between 275-300 basis points (a basis point is 1/100th of one percent). Thus, if your bank requires a 300 basis point spread over the 10-year to cover its costs and make a profit, your mortgage interest rate is 5.00%.
The 5.00% rate on your mortgage is your cost of capital, but you too need to make a profit, so you have to add a spread of your own. A good starting point is 300 basis points. At that spread, the cap rate in our example is 8.00%.
To determine your rental expense, you would multiply your cap rate by the property’s fair market value. The stronger the documentation and logic supporting both your real estate appraisal and your assumed cap rate, the smoother and faster the negotiation process is likely to flow.
Dealership real estate is less frequently traded and thus less liquid than other facilities, so getting a credible baseline cap rate can be a challenge. The best source of the prevailing cap rate for car dealerships is a real estate services company such as Cushman & Wakefield or CBRE, each of which has dealership-related expertise and up-to-date data by market area.
The national average cap rate for car dealerships currently is 7%. Your cap rate as a spread on top of your cost of capital is only a starting point for arriving at your specific cap rate. Just as your location and dealership is unique, so is your cap rate.
Major variables that will drive your cap rate up or down based on risk are:
- The quality of your market and your location in that market. The real estate of a dealership in Beverly Hills located on a major thoroughfare will have a lower cap rate than a dealership located in a rural area;
- Strength of your franchise(s);
- Alternative uses of the property, meaning, can your property be something other than a car dealership?
Why go to all the trouble of setting a rental expense that is based on a well-documented estimate of what a knowledgeable, independent third party would charge? Why not just settle for a “ballpark” estimate so as to give yourself flexibility in the bargaining process? You want to look smart to your buyer and have strong analytical support for why the rental expense you think should be used in determining your blue is right. Getting to “yes” becomes a lot easier if you have a strong, well-presented fact case.
It is counter-intuitive, but true that you should somewhat overcharge your dealership for rent. The tax rate on your rental income tends to be less than the tax rate on your store’s operating profits. Your accountant of course would have to verify that this generalization applies to you.
If the cap rate you use to establish a pro forma rent is above market, the rent you have been charging your dealership will be adjusted downward in the negotiation process; therefore, your blue will be adjusted upward. For example, suppose you have a property appraised at $10 million and are paying rent based on a 9% cap rate, but the market cap rate, based on your analysis, is 8%. At a blue sky multiple of 5x, the incremental valuation of your dealer operation is $500,000 ($900,000 rent paid less $800,000 pro forma rent) times 5.
In sum, to get the highest possible value for your dealership and to assure the smoothest possible negotiation process, you must have an in-depth understanding of the value of your real estate – both its market value and how much rent to charge your store.
Cushman & Wakefield Dealership Capital Services (DCS) specializes in buy/sell transactions, partner buyouts, equity solutions, debt restructuring and sale-leasebacks. James Mitchell has over 20 years of automotive industry experience. He can be reached at james.s.mitchell@cushwake.com or (202) 407-8120.
