In the first quarter of 2018, dealership rents rose considerably on a quarter-over-quarter basis (see Chart 1). This increase is both a blessing and a curse for many dealers. It’s a blessing because rising rents reflect rising property values, and a curse because rising rents mean higher fixed expenses and lower earnings.
Rising rents are primarily a result of rising commercial real estate values, predominately driven up by a decade of broad credit availability and attractive mortgage terms. As real estate values inflate, dealers who own their real estate have seen their enterprise value increase despite lower industry profits (see Chart 2). According to Kerrigan Advisors’ research, on average, dealership real estate prices have more than offset the slight declines in average blue sky values over the last 18 months.
While increasing real estate values are a tremendous blessing for dealers and their families, particularly if they are considering a sale in the near-term, they are often a curse for dealers who are staying the course or are looking to expand their group. Rising rents, a fixed rather than variable expense, reduce earnings and add risk to the auto retail business model. The fixed nature of rent also hampers a dealer’s ability to manage through economic cycles. During the Great Recession, high rent expense caused the downfall of many dealers.
In the first quarter of 2018, average dealership rent hit a level not seen since the recession, rising to $959 per new vehicle retailed (see Chart 3). These rent factors are an alarming trend, particularly given the recent decline in new-vehicle gross profits.
In addition to rising real estate values, rising rents can be attributed to OEM demands for new image facilities and expensive remodels. This is particularly true with luxury franchises whose rent per new vehicle retailed averaged a stunning $1,808 in the first quarter of 2018, almost double the industry average.
Luxury franchises’ rent to gross is currently 13.2%, 28% higher than domestic franchises despite luxury’s significantly higher dealership gross profit (see Chart 4). I attribute this high level to the incredible demands for expensive facilities by most luxury OEMs. These demands not only seem tone deaf with current retail trends against brick-and-motor investing, but also economically extravagant and financially irresponsible (see Chart 4).
In today’s market, image requirements are increasingly pushing dealers to sell their franchises. These dealers are unwilling to invest the capital required to become facility compliant and would rather “cash out” than “lever up” on real estate. Unfortunately for dealership sellers, blue sky discounts for major image construction projects are on the rise in 2018’s buy/sell market. Buyers are increasingly wary of high rent factors and the risks associated with immovable expense structures and operational disruptions from major construction projects.
“The new car model is completely broken right now because of the expectations of what these manufacturers have out there in the cost of these facilities. It doesn’t pencil, the model doesn’t work, and something’s got to budge. And right now that’s, in my opinion, devaluing some of these franchises.”
– Scott Smith, Chairman & CEO, Sonic Automotive, First Quarter’s Earnings Call
As interest rates and concomitantly cap rates (see Chart 5) continue to rise, image requirements will become an even more divisive issue in dealership transactions and OEM relations.
Over the last ten years, healthy credit markets and low interest rates have enabled OEM demands for increased real estate spending. With a changing credit landscape, image facilities will become more difficult to justify, particularly as online sales grow. If OEM facility demands continue at their current pace, I expect dealers’ rallying cries against facility requirements could reach deafening levels. Let’s hope economically rational heads begin to prevail to avoid such a conflict!