Industry Perspective: Rising Interest Rates Present M&A Challenges, Opportunities

Rising Interest Rates

Present M&A Challenges, Opportunities

Interest rates may reduce merger and acquisition activity, but growth-oriented small and mid-sized retailers may benefit from more traditional purchase multiples.

Mark Radosevich • PetroActive Services

As we enter the second half

of 2022, the petro mergers and acquisitions (M&A) environment remains positive for both retail and commercial acquisitions.

However, current actions by the Fed to counter inflation by raising interest rates and the resultant cost of money may begin to dampen M&A enthusiasm, while moderating cash flow valuation multiples and corresponding deal values. Store buyers will be hit with a double whammy in the areas of higher mortgage interest rates and rent/lease capitalization rates (cap rates).

Real estate portfolio buyers will face higher mortgage payments and equity contributions, as loan-to-value leverage amounts may also increase due to higher lender loan security concerns. Correspondingly, buyand-lease store operators will face a combination of lower post-closing sale-leaseback proceeds and higher rent expenses due to higher cap rates.

Large publicly traded c-store chains enjoy “credit tenant” designations generally superior to other retail or quick-service restaurant companies. This is partially the result of the resiliency our industry demonstrated during the pandemic and the strength of the underlying real estate. Despite recent interest rate increases, credit tenant cap rate values remain in the 4% range, as leases were negotiated prior to rate movements. They will move higher as future deals are consummated within the higher interest rate environment.

Many former marketers entered into long-term leases with these large national chains to forestall the tax consequences of an outright real estate sale. They will unfortunately see the underlying value of their leases diminished as cap rates increase.

A currently leased site that earns $45,000 in annual rent at a 4.5% cap rate would be valued at $1 million ($45,000/.045 = $1 million). Assuming the cap rate for the same c-store operator/tenant increases from 4.5% to 5.5% due to rising interest rates, the underlying value of the same lease would be $818,182 ($45,000/.055 = $818,182) or $181,818 less, if the marketer decided to sell that lease.

For those that hold leases on multiple sites, the value impairment would be significant, if the initial exit plan entailed flipping the leases. This secondary, post-closing cash tranche from a lease sale is what drove many deal values to historic highs. This value impairment only affects those that planned on selling the lease(s) prior to their termination. For those that plan on holding the leases for the long haul, there’s no harm, no foul, beyond their rental income being less than it would be under a new lease with the sale tenant.

On the commercial side, rising interest rates, combined with the increased cost of fuel is a twoedged sword. To manage monthly receivables and credit float, smaller fuel and lubricants distributors will be challenged by higher levels of lender credit requirements and guarantees. Those that can’t contend will be forced to limit operations or exit the industry. Conversely, well-heeled operators will experience previously unavailable acquisition candidates and opportunities.

TACTICAL GROWTH PLAN

If there is anything good to come out of this Biden administrationinspired inflation mess, it is that small and mid-sized marketers may finally be able to make an acquisition at more traditional purchase multiples. For the growth oriented, it’s time to create (or dust off) a tactical growth plan that includes: • Create a profile of a preferred acquisition candidate and geographic area. • Develop a target list of candidates and contact each to establish an early dialog. Become the top-of-mind buyer candidate in the event one decides to sell. • Amass and segregate available equity for when an opportunity arises. • Enlist reliable lender partners.

Jointly pre-determine your optimal deal capacity.

Growth-oriented marketers should “keep their powder dry” and be prepared to pull the trigger when an appropriate acquisition arises. Rest assured that opportunities will be plentiful over the months to come.

Mark Radosevich is a strong industry advocate, recognized petroleum veteran and president of PetroActive Services (Petroactiveservices.com). Reach him at mark@petroactive.net or (423) 442-1327.