The effect of a rising interest rate on dealership valuations

By James Taylor, Managing Director, The Presidio Group

For decades, financial advisors have been queried by dealers about projected moves in interest rates. “Are rates going up or down?” The informed but vague answer was “Yes!” indicating rates would do one or the other. Since 1981, interest rates have trended down with numerous increases and decreases along the way. Today’s rates are slightly up from their 35-year low making operating interest expense in dealerships near historic lows. It’s great for business, no question.

This environment is changing. Today the answer to the interest rate question seems obvious: Rates have been going up! The Federal Reserve increased its benchmark interest rate by 0.25% in June for the fourth time in 18 months. All indications are that the Fed will continue to increase rates.

The Presidio Group is often asked how dealership valuations are affected by rising interest rates. We see three key drivers reducing dealership valuations in an increasing rate environment:

1.  Higher financing costs to acquire and operate dealerships.
2.  Higher returns demanded by dealership acquirers and investors.
3.  Higher customer financing costs resulting in lower sales and thus lower profits at dealerships.

Since the March 15 interest rate increase, the U.S. Treasury Note’s 10-year yield has averaged approximately 2.30%. To illustrate the return hurdles required by dealership buyers, we apply this risk-free return to a simplified dealership valuation.

• First: Assume that the dealership generates $10 million in annual pre-tax profits and that buyers would require a 20% annual return on their equity investment in today’s interest rate environment.
  • We have assumed that this would result in a $100 million valuation to produce this 20% return with 50% equity and 50% debt financing.
• Second: Analyze the effect of 2% and 5% increases in the 10-year Treasury yield to 4.30% and 7.30%.
  • In the +2% scenario, a $100 million dollar investment would need to generate an additional $2 million in cash flow to compensate for the 2% risk-free rate increase. If investors are not able to realize these higher required returns from a dealership, financing dollars will leave the industry for higher return or lower risk investments.
  • As a result, the valuation for the dealership business decreases 22% to $78 million from a 2% increase in interest rates.
  • Similarly, a +5% scenario would drive the value of the dealership down by 42% to $58 million.

To further complicate the scenario, profits generally decrease in a rising interest rate environment with pressures from tighter consumer credit and increased borrowing costs. We simply decreased profits to $9 million in a +2% interest rate environment and to $8 million in a +5% environment but realize that the pressure on profits could be more substantial.

We have enjoyed historic low rates since 2008, which hit a 35-year low in July 2016. However, a 10-year Treasury of 4.30% was normal from 2004 to 2007 following the dot-com bubble burst recovery and 7.30% was normal from 1994 to 1999. With the unemployment rate under 5% and increased inflation concerns, further increases in interest rates from the Federal Reserve are anticipated in the near-term.

Interest rates have always been a highly sensitive cost of doing business for dealerships. Dealers and consumers will need to adjust to further interest rate increases. This will increasingly challenge dealers across the U.S. turning the long-standing seller’s market into more of a buyer’s markets for dealerships. If a dealership organization is anticipating selling in the near future, now is an opportune time to do so.

James Taylor is Managing Director of The Presidio Group, a merchant bank in San Francisco specializing in automotive investments and transactions.  He can be reached at jtaylor@thepresidiogroup.com or 415-449-2520.

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