For decades, financial analysts have been queried by dealers about moves in interest rates. “Are rates going up or down?” The informed but vague answer was always, “Yes!” Of course, rates would do one or the other. In perhaps the greatest period of U.S. prosperity, interest rates have come down a long way the past 36 years since peaking in May 1981. However, this favorable environment has changed over the last 20 months as the Federal Reserve increased its benchmark interest rate by 0.25% 6 times from its targeted range of 0.25-0.50% in December 2015 to its current targeted range today of 1.75-2.00%.
Furthermore, all indications are that the Fed will continue to increase rates and may very well return to more typical past levels. Since the inceptions of the Federal Funds Rate in 1954, there have been 9 interest rate cycles with an average length of 7 years with a minimum of 3 years and a maximum of 11. Target short term interest rates reached a high of 20.00% in May 1981 and a low of 0.00% from 2008 to 2015. The average trough-to-peak increase in the 9 interest rate cycles was 6.15% with the smallest increase of 3.25% and the greatest increase of 15.25%. Nobody knows how high interest rates will rise during this tightening cycle nor how long this tightening cycle will last. We do know, however, that financing costs to both the dealer and consumers will increase and the ROIC hurdle rate required by investors will also increase. With the unemployment rate below 4% and increased inflation concerns, further 0.25% quarterly increases in interest rates from the Federal Reserve are projected.
Auto retail, of course, is highly sensitive to interest rates. Generally, the longer interest rates are low, the easier it is to make greater profits and the more complacent operators become. This time the interest rate increases are more severe because of the baseline level of near zero borrowing costs since 2008. If rates were to rise 3.00%, the increase from 0.50% to 3.50% would be the same nominal increase as for example from 7.00% to 10.00% but the magnitude of change of the former is a 600% increase while the latter is only a 43% increase.
Annually since 2014, Presidio has analyzed the negative effect of rising interest rate environments on dealership valuations. The value of dealerships decline in a rising interest rate environment because of (1) higher financing costs and (2) higher return on invested capital (ROIC) demanded by investors.
In order to understand the interest rate environment, we start with a 5-year look back at the Federal Funds Rate. While most dealers are likely more familiar with LIBOR, particularly from floorplan interest, we use the Federal Funds Rate for longer data history since the Fed Funds Rate was introduced in 1954 while LIBOR started in 1986.
Since the end of 2015, the Fed Funds Rate has increased 1.50%. At Presidio, our analysis shows a 6% decrease in dealership value for every 1.00% increase in interest rates. Therefore the 1.50% current increase in interest rates should lead to a 9% decrease in dealership valuation without taking into account a number of other factors that could enhance or further decrease valuation.
In the past, these market cycles have come and gone and were good opportunities to buy at lower valuations. However, this time may be much different (and really different). That is because the auto industry rate and scale of change is now greater than it has been in the previous 100 years due to a number of disruptive trends and developments that will significantly change the traditional auto dealership model. We do not know how high interest rates will go nor how long this increasing interest rate cycle will last, but it could run several years and possibly end just as the industry begins to really feel the powerful effects of disruptive forces. That would mean that indiscriminate buying on the market dips is no longer a guaranteed long term strategy in the face of a disrupted automotive world.
For any questions please contact James Taylor
Phone: 954 415 9105