For decades, auto dealers have asked financial analysts, "Are interest rates going up or down?" The answer was always, "Yes!"
In perhaps the greatest period of U.S. prosperity, interest rates have come down a long way since peaking in May 1981. But the favorable environment has changed over the past 20 months as the Federal Reserve increased its benchmark interest rate 0.25 percentage points six times — from its targeted range of 0.25 to 0.5 percent in December 2015 to its current targeted range today of 1.75 to 2 percent.
Furthermore, all indications are that the Fed will continue to increase rates. Since the inception of the federal funds rate in 1954, there have been nine interest rate cycles with an average length of seven years — a minimum of three years and a maximum of 11. Target short-term interest rates reached a high of 20 percent in May 1981 and a low of 0 percent from 2008 to 2015.
The average trough-to-peak increase in the nine interest rate cycles was 6.15 percentage points with the smallest increase of 3.25 percentage points, the greatest increase of 15.25 points.
Nobody knows how high interest rates will rise during this tightening cycle nor how long this cycle will last. We do know that financing costs to dealers and consumers will increase and the higher return on invested capital hurdle rate required by investors will also increase. With the unemployment rate below 4 percent and increased inflation concerns, further 0.25 percentage point 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 be profitable 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 percentage points, the increase from 0.5 to 3.5 percent would be the same nominal increase as for example from 7 to 10 percent but the magnitude of change in the first case is a 600 percent increase while that in the second is only a 43 percent increase.
Each year since 2014, Presidio has analyzed the negative effect of rising interest rates on dealership valuations. The value of dealerships declines as interest rates rise because of higher financing costs and higher return on invested capital demanded by investors.
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, or the London Interbank Offered Rate, particularly from floorplan interest, we use the federal funds rate for longer data history. (Libor started in 1986.)
Since the end of 2015, the fed funds rate has increased 1.5 percentage points. At Presidio, our analysis shows a 6 percentage point decrease in dealership value for every 1 percentage point increase in interest rates. Therefore the 1.5 percentage point increase in interest rates should lead to a 9 percentage point 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. But this time may be much different. That is because the auto industry rate and scale of change is now greater than it has been in the previous 100 years because of disruptive trends that will significantly change the auto dealership model.
High interest could run several years and possibly end just as the industry begins to 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.