Dealers often assume that dealership real estate is a good investment. In this low interest rate environment, why wouldn’t you buy your property, particularly if you have the capital for a down payment and can get financed? Commercial mortgage rates are currently between 6% and 7%, while lease rates are around 8%. So, why would you lease? As it turns out, there may be a good reason: your opportunity cost of capital (the return you would make on an alternative investment).
Compare the return on equity (ROE) of an investment in your dealership versus an investment in your real estate. According to NADA, the average dealership in the U.S. achieved a 25% ROE in 2010. If we look at average dealership ROE over time, Chart 1 shows that even with the recent recession, dealership ROE averaged over 23%, between 2000 and 2010. Such a high rate of return may seem normal to dealers, but it is not standard for most businesses. Few industries average 20%-plus ROE.
Chart 1: Average Dealership Return on Equity (ROE)
Source: NADA
By contrast, commercial real estate investments have historically produced less than a 20% ROE (the 2005-2007 bubble being the exception, which is unlikely to ever become the rule). Today, as commercial real estate lending returns, dealers are once again able to finance their real estate purchases. Chart 2 shows the estimated range of real estate ROE dealers can expect (the yellow box represents the current market), subject to different mortgage rates and real estate appreciation assumptions. As you can see, only in the most aggressive case (not the average), do dealers achieve a 20% ROE, far below the average dealership’s 25% ROE.
Chart 2: Dealership Real Estate Return on Equity
*Assumes 75% loan to value mortgage, 20-year amortization, and a six-year hold period, also assumes dealership pays full cost of mortgage payments, property taxes and insurance
If dealership ROE averages ~ 66% higher than real estate ROE, it would make sense to invest all of your excess capital into your business, rather than your property. Yet, this rarely happens. Most dealers still insist on owning their own real estate partly because mortgage payments are generally lower than lease payments. This pricing disparity actually makes sense as it reflects the higher risk associated with a lease. Leases are equivalent to 100% real estate financing for a long term. By contrast, mortgage financing is usually in the 75% range for a shorter term and thus is lower risk and less expensive.
The additional operating cost of leasing often leads dealers to determine that real estate ownership is the best investment option. This assessment fails to address the investment’s opportunity cost (the cost associated with passing up your next best investment option). For most dealers, a property investment precludes further investment in their dealership, the next best investment option.
Chart 3 is an example of how to calculate the opportunity cost of buying your dealership real estate. It is determined by calculating the net present value (“NPV”) of the expected cash flows you would have earned had you invested in your business, rather than your property. To calculate the NPV, you must deduct the additional annual cost you would have incurred by leasing rather than owning your property (if such a cost exists). As you can see in the example in Chart 3, owning your real estate can result in a sizable opportunity cost.
Chart 3: Example of the Opportunity Cost of Dealership Real Estate Ownership
Chart 4: Opportunity Cost of Dealership Real Estate Investment Relative to Mortgage Interest Rates and Lease Rates, Based on Chart 3 Assumptions
Chart 4 further examines how the opportunity cost of real estate ownership can change relative to mortgage and lease rates, based on Chart 3’s assumptions. In this example, only when lease rates are at 10% and mortgage rates are at 5% does it make financial sense to own rather than lease. To be clear, this example assumes that dealers can invest additional capital into their business at a 25% ROE. If such an opportunity does not exist, then this analysis would need to change to reflect the expected dealership return.
In summary, as with most investing, your decision to own or lease depends on multiple factors. Clearly, there are many strategic reasons to own your dealership real estate, including: (i) increasing the marketability of your franchise when you sell, (ii) locking in control of your dealership location, and (iii) having financing flexibility for expected facility upgrades, to name just a few. All of this said, by calculating the opportunity cost of real estate ownership, you will be better informed when making your investment decision. Regardless of which decision you make (rent or own), the good news is that the economy is improving and both investment decisions will likely have a positive outcome. Choosing between an expected 15% and 25% ROE is great problem to have!
