By Alysha Webb, Editor and Publisher
Low interest rates and record new car sales have provided a sturdy floor for hefty dealership valuations. Now, there is general agreement the Federal Reserve will raise interest rates next week for the first time since 2006.
Will that erode support for dealership valuations? Not in the short term, say industry experts. But dealers should be ready for the impact that steadily rising rates will have on their franchise value.
“When the SAAR comes down in a few years and rates go up a few points, that is going to have a big impact on valuations,” Mark Johnson, president of MD Johnson, Inc. tells Automotive Buy Sell Report.
Interest rates have not risen since 2006 and the Federal Funds Rate has languished below one percent. That has meant that borrowing funds to acquire dealerships has been cheap, as well. Car loans have been cheap, too.
The U.S. economy seems to be coming out of its long slump, however, and the Federal Reserve has hinted it is time to make borrowing money a bit more costly.
The Federal Open Market Committee, which sets the target for funds that banks lend each other, is due to meet on December 16. The Fed is widely expected to raise interest rates at that meeting.
“Psychologically, it will create a lot of doubt initially,” says Johnson. But, “rates will still be really low, and payments have been so artificially low that people will think about [the rate increase] and blow through it.”
In the short term, the rise also won’t have much impact on light vehicle sales, which LMC Automotive forecasts will hit a record 17.5 million units in 2015.
“Even with the strong possibility for the Fed to increase interest rates, growth should continue into 2016, with sales expected to reach 17.8 million units,” said Jeff Schuster, senior vice president of forecasting at LMC Auto.
The initial rate rise is likely to be only 25 basis points, which won’t be passed on to consumers, Steven Szakaly, chief economist at the NADA tells Automotive Buy Sell Report.
“It is not going to do anything to car sales because OEMs and dealers are going to eat the first 25 to 75 basis points anyway,” he says.
But there are storm clouds on the horizon. Retail sales growth is expected to level off by 2017. Meanwhile, rising car loan lengths mean consumers could be saddled with higher payments in the last few years of their loan. The average loan length now is close to 5 ½ years and still rising.
Dealers themselves will see their bottom lines negatively impacted by steadily rising interest rates, says Szakaly. The low rates have effectively provided a “massive subsidy” for floor plan credit, he says. That will go from being neutral or an income item on the balance sheet to becoming a cost item.
But it will happen very, very slowly, he says.
“It is going to be like the frog in boiling water effect. A lot [of dealers] could get cooked but they won’t know it. Dealers must be ready and be aware of rising interest rates,” says Szakaly.
In the buy/sell world, the long-term impact of steadily rising rates will be subtle but dangerous.
The cost of borrowing money to acquire a dealership won’t rise immediately, James Taylor, managing director of The Presidio Group tells Automotive Buy Sell Report.
“The first thing that happens is the manufacturers absorb some of it, the dealers do it with further compression of margins, and eventually people get used to it,” he says.
Rates are forecast to rise by as much as 200 basis points over the next 18 months, however. That could lead to a dramatic decrease in dealership valuations, says Taylor.
Presidio’s modeling shows that an increase in the Federal Funds rate to 2.25 percent would result in a 22 percent decrease from today’s values if all other factors, including brand, market, people, presence, and productivity and performance remain equal.
Rising rates may also squeeze smaller groups out of the buy/sell market.
Taylor says Presidio is seeing lenders aggressively pursue new loan business, and requiring nominal equity from the most qualified buyers. That is leading to loans with high debt to equity ratios.
“These are not fixed rate loans,” says Taylor. “It is incumbent upon the new owner to either improve operations so they can pay a higher level of interest or assume their cash flow will go down.”
The scenario favors large, well-capitalized groups with cash, says Taylor. They are the ones who will be able to execute acquisitions. Dealerships or groups that are carrying loans may have to sell, depending on how much they are leveraged, he says.
“God forbid there will be a downturn in new and used car sales,” adds Taylor.
Photo credit: FutUndBeidl via Foter.com / CC BY
