Finishing Line - March 2008

Build, Buy, or Lease?:
The Choice can Determine Your Risk

By Robert Roman

Each day, there are thousands of people who consider the possibility of building a new car wash or buying or leasing an existing operation.

Building a full-service for $3 million or an express exterior for $2 million has the risk of capital loss. Capital loss is a function of real estate-development and investment-ownership risks as well as business-operating risks. Development and investment risks can be mitigated to a certain extent with due diligence — can permits be obtained, is the land contaminated, can the project be built on time and budget, and can the business be leased or sold to a third party buyer in the future?

VARIED RISK

Faced with these risks and the reality that it may take two years or more before the first vehicle is washed, some investors will consider buying or leasing a car wash. This approach eliminates development risk and can reduce investment risks if it lowers the investor’s out-of-pocket expenses.

The business-operating risks associated with buying or leasing are the same as building a new wash. This includes competitive risk — will the site produce adequate gross sales — and operations risk — will adequate management be provided to ensure an effective economic and customer-centric operation? In this case, the buyer should evaluate: what is a fair price; are the books clean; what are the liabilities; is there an upside to the market; how many competitors are there; can the business be improved on; how long will it take to recover the investment; how long is training after the sale; what is included in the sale; is there a non-compete; and what are the exit strategies?

VALUE

The most common form of lease is “triple net.” Triple net is very popular because the rent collected by the landlord is free and clear of any obligation to pay the cost of property taxes, insurance, and maintenance. In this case, the price of the business includes goodwill and personal property such as equipment, furniture and fixtures, and inventory. The value of personal property can be determined by using authoritative sources to estimate the going-concern value of these assets subject to accumulated depreciation.

Determining the value of goodwill is another matter. Goodwill is the sales and profit-making capability of a car wash business now and in the future. It is generated from the competitive advantage associated with name, image, customer-service reputation, financial performance, and location. In this respect, the value of personal property assets is only incidental to the future of the car wash business. It follows then, that the value of the car wash business should be determined by capitalizing future earnings.

CAP RATE

The capitalized value of a car wash is the value that would bring stated earnings at a specific rate of interest. From the buyer’s perspective, this rate should represent the desired return on investment for investments involving a similar amount of risk. The higher the risk, the higher the rate of return should be. This is especially important for buyers because the risk involved with owning and operating a car wash can vary considerably over time and by type of car wash. In fact, it is often advisable for new investors to consider ratcheting the cap rate up by a few points to compensate for their lack of industry experience.

The use of cap rates is widespread in the real estate industry because it is easy to calculate and is commonly understood. If you divide net operating income (EBITDA) by the purchase price and multiply by 100, the result is a capitalization rate that can be used to evaluate comparable car wash sales. Conversely, if the overall cap rate in an area is 12 percent, an on-going business with NOI of $75,000 should have a sale price of about $625,000 (75,000/0.12).

One of the limitations of cap rate is that it only provides a current snapshot of the property’s first year rate of return. As with any lease, the terms must be long enough to allow the tenant/operator sufficient time to recover the investment while making a profit. Typically, a retail business with an ROI of 15 percent to 20 percent has a five to seven year window. Another limitation of cap rate is that the broker’s advertised rate could be very misleading if the seller has cooked the books or misrepresented the definition of NOI.

In the final analysis, the book or appraised value of a car wash business means nothing if there are no interested buyers. As such, buyers should evaluate a car wash business by determining if the price will allow them to make a decent salary, make payments to the bank to cover the cost of borrowing, and make a respectable return on investment on the equity the buyer puts into the deal.

Robert Roman is an analyst and lead consultant for RJR Enterprises, a consulting firm based in Clearwater, FL (www.carwashplan.com). You can reach Bob via e-mail at rjrcarwashplan@yahoo.com.

 

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