Dealership Real Estate and “Blue Sky”
By Jay A. Goldman, CPA
As published in the winter 2023 edition of Headlights. View the complete edition.
We are routinely asked to assist clients evaluating potential dealership transactions.
Among the first two questions we ask are:
- Has the real estate been appraised?
- Is the facility image compliant?
If the answer to either of these questions is no, it is difficult to properly assess the amount of “blue sky” inherent in the deal. Blue sky is a function of the annual profits a store is expected to produce. Consequently, the multiple is the number of years a buyer is willing to work for a seller. The investment in image-compliant real estate translates into the future rent factor, which of course is the largest fixed expense a dealership will incur and will have a direct impact on potential profitability.
It is not unusual for a dealer to think that the rent factor is not that important because it is self-charged and can therefore be whatever a dealer wants—provided the mortgage is covered. We think that approach is short sighted. Dealers are in multiple lines of business simultaneously, at a minimum: the dealership and the real estate (frequently, insurance, as well).
Each of these lines of business should be evaluated on a stand-alone basis. The proper return on an investment in real estate changes with interest rates and geography, but recently we have been using 7.5% as the benchmark when working with clients. So, if you pay $10m for the real estate, the rent would be $750,000. That rent factor should then be built into your projection for the profitability of the dealership, which relates to blue sky based on assumed multiples.
Let’s assume a prospective buyer enters a Letter of Intent (LOI) indicating they will pay appraised value for the real estate. Let’s further assume that they expect the real estate to appraise for $10m and believe the facility is image compliant. Now, let’s assume the appraisal comes back at $12m OR an additional investment of $2m in improvements is required to satisfy manufacturer facility requirements. Now, the rent should be $900,000 annually ($12m × 7.5%). The dealership is now $150,000 ($900,000 – $750,000) less profitable. Assuming a multiple of 5, the computed blue sky would have been $750,000 less.
In many ways, the relationship between the real estate and the goodwill is like that of the car being purchased and the car being traded in. Neither exists in a vacuum, and the value of one has a direct impact on the other. The greater the investment in real estate, the greater the downward pressure on the value of the franchise.
If you would like to discuss this further, please contact me at firstname.lastname@example.org or 717-761-7210.