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AutoNation CEO Mike Jackson recently told CNBC that the end of the Fed “free-lunch” won’t hurt them; implying that the current low-interest rate environment is about to change. What will this mean for dealers without the balance sheet of a publicly traded group?
The Wall Street Journal recently reported signs of healthy growth and diminished slack in the labor market in “Job Gains Support Fed Plan on Rates.”
From the report:
Employers have now added an average of 235,000 jobs a month over the past three months, and the unemployment rate is holding at its lowest level in more than seven years, signs of healthy growth and diminished slack in the labor market.
The latest figures likely met the Fed’s latest threshold for an interest-rate increase sometime this year, possibly as soon as September. The central bank last month said it wanted to see “some” further improvement in the labor market before lifting its benchmark interest rate from near zero, where it has sat since late 2008. Fed officials expect that tightening in the labor market to eventually lead to an acceleration in wages and overall inflation.
You may be saying to yourself, “enough of the Wall Street talk, what does this mean for a dealer my size?”
It has been nearly 10 years since the federal funds rate has increased. Albeit gradual, analysts and reports from the Fed all indicate the increases are coming. Normalizing monetary policy will surely affect real estate values, rent factors, cash flow, and operating expenses for dealers.
Let’s look at what this implies for the average dealer and the tools to help mitigate some of the risk of higher cost of capital.
Increased cost of real estate financing
Currently many dealers have a low interest rate on a floating rate adjustable loan or a 3 to 5 year fixed rate. Depending on the date of inception, the maturity due dates on these 3 to 5 year note is not too far off. When refinance time comes, an appraiser (and therefore the lender) will think like a buyer applying three standard valuation methodologies to process: replacement cost, sales comparison, and income approach to value (or discounted cash flow).
The cost approach is simple: What would it cost to replace your building? Then subtract the depreciation and add the market value of the land. This valuation methodology takes into consideration and adjusts replacement costs based upon a published industry standard geographic cost index. In the sales comparison method, the appraiser looks for like properties, in like markets, and ideally by the same franchise to determine what an individual would expect the value to be based upon these sales. The income approach, or discounted cash flow, quite simply says at the market interest rate and your current rent payment, how much is your building worth.
As interest rates increase, the value of real estate generally goes down. This is similar to the value of a fixed income bond or security where price and interest rates move in opposite directions. Let me explain a bit further.
If income from an investment is fixed for a period of time, investors want an increase in their rate of return in a rising interest rate environment. Analysts will make future value determinations using a market capitalization rate.
The market cap rates are derived from the market and based on factors including interest rate, investors’ required return on equity, liquidity premium, recapture value, and risk premium.
Consider this: what are the results if the cap rate increases by 1.5%, or 150 basis points? In this instance, we’ll assume an annual triple net rent of $600,000 and apply the cap rate to determine building value.
7.5 Cap Rate
600,000 ÷ 0.075 = $8,000,000
9.0 Cap Rate
600,000 ÷ 0.09 = $6,666,666
As you can see, the 150-basis-point move from 7.5% to 9% effects loan-to-value substantially when value is reduced by $1,333,333. The impending environment will force dealers to 1) make critical adjustments to down payments (affecting operating capital) and 2) prioritize paying down debt.
Affects on floor planning
Fortunately for dealers, most of us receive “floor plan assistance” on our new vehicle inventory. Velocity of inventory turns begins to take on a new meaning as interest rates increase. I suggest that you monitor your new inventory turns to make certain that your floor plan credits exceed the cost of floor plan. As rates go up, if you want to keep floor plans costs down you need to turn inventory faster.
Since your cost of capital to inventory used vehicles is not subsidized, the turn rate becomes of even greater importance. There are many methods to monitor used inventory turns. I suggest you use one of the systems and monitor it daily.
Operating loan costs increase
In a period of low interest costs, we are not as diligent as we are when rates increase. In practice, we should be aware in good times and bad of our capital costs. Now is a good time to increase oversight on loan costs.
As lending institutions’ cost of capital increases, so will the cost of your loans. The rate of interest will vary based on many factors. One of the most frequently used factors is your debt to equity ratio. The $1.3M of lost equity from our example will have a negative effect on your debt to equity ratio, which may raise your risk profile.
Cash flow change
Normalization will also have repercussions on cash flow. As already mentioned, refinancing will likely require a greater down payment taking operating capital out of the business. Increased costs in used car floor planning and operating loans will tighten cash flow as well. Lending institutions become much more stringent on floor plan curtailments.
Consumer financing interest rate increase
Lending institutions look at four main factors when setting rates: cost of capital, interest rate margin, duration, and risk.
Interest rate increases change debt-to-equity ratios for your retail customers as well as businesses in your community. For customers that have cash to deposit at lending institutions, there are benefits to be realized in raising rates. My experience is that there are far fewer customers who benefit than those that are adversely affected by increased rates.
When I was operating my stores, I consistently challenged myself to strategize today for the environment tomorrow. As I consider the implications of the Wall Street Journal article I referenced, the slack in the labor market creates another pressure on dealers: higher wages. While both increased labor costs and upward movement in interest rates affect our balance sheets, small businesses can win with diligent risk assessment and a proactive asset and liability management strategy.
In light of the recent stock market dive, we may have bought ourselves another 90 days from the originally predicted September hike.