Rational Expectations - Consider Differences in Models and Reality
By Robert Roman
Some years ago, I received a call from an investor who was building an exterior express car wash in the Rocky Mountain region. His question was simple: Do these things ever fail?
Not only did I find this question odd, considering the phase of project, I found it somewhat difficult to answer. After all, how do you define failure? Is it a vacant building, missed sales projections, break-even, for sale by owner, bank-owned property, or some other metric?
In simplest terms, failure is lack of success. For example, the risk to develop a car wash is categorically similar to those found in any retail store development.
One risk of real estate development and investment ownership is re-sale market risk. Will future market conditions allow the sale (or lease) of the project to a third-party buyer for the expected price?
Figure 1 – Capture rate
Arguably, this risk in a car wash project is typically greater to what it is in a traditional retail store project. The reason is that, unlike a Dollar General store, a car wash operation just can’t pack up its merchandise and shelves and move to another site location if sales are inadequate.
Consequently, realistic estimates of volume levels needed for loan pay-off and recovery of investor’s equity is crucial. Realistic means developing a practical idea of what can be achieved or expected.
Several years ago, I was engaged by an investor to prepare a feasibility study for an exterior express project in the southwestern United States.
In discussing the assumptions used in the pro forma financial projections, the investor told me, “What we are seeing here is a capture rate of 1.5 percent.”
To accept this, similar conditions would exist between the stores in the analogue. This means comparable property and store size, highway geometry, visibility, access, lot position, prices, demography, and other factors that are thought to influence car wash sales volumes.
In my case, this was tough to accept on face value alone because industry standard software suggested that a capture rate of 0.9 percent would be more appropriate. However, this difference did not affect the findings presented to the bank.
Based on a capture rate of 0.9 percent, the expected selling price would pay off the loan, return the investment equity, and provide an acceptable return on investment.
Of course, my dilemma was that this result was considerably less than the investor’s expected return based on capture rate of 1.5 percent. Why is it important to consider differences that exist in expectations, models, and reality?
One reason is shown in Figure 1. The attraction rate and customer loyalty rate of a car wash business change over its life cycle. In the beginning, customers are new and there are few repeats during the first months of operation. However, over time, more and more customers become loyal. After a car wash matures, the customer loyalty rate may be 75 percent and the attraction rate only 25 percent.
Figure 2 – Competition
Another reason is shown in Figure 2. Goodwill is all the things that make a business effective such as practice, reputation, location, track record, and procedures that lead to superior income.
Arguably, a business with considerable goodwill may lose some of its customers to switching costs, but no one should expect it to just roll over.
Bob Roman is president of RJR Enterprises – Consulting Services (www.carwashplan.com). You can reach Bob via e-mail at email@example.com.