With interest rates rising recently business buyers and sellers may wonder, “Will increased interest rates affect the value of a business being sold?” Spoiler… small changes in interest rates do not dramatically affect the value of a business or the net after debt service. In fact, a 0.25% interest rate increase only increase the annual debt service by roughly $3,000 per year on a $1 million transaction.
While rates have risen from a recent low of 3.25% in 2008 to 5.25% in October 2018, these are far from what would be considered high rates and are actually approaching normal rates in a healthy economy. The all time high Prime Rate was a whopping 21.5% in December 1980 and the all time low rate was 1.75% in 1947, in May of 2000 the rate was 9.5% and it was generally between 4% and 8% throughout the 2000’s, until is was dropped after the recession.
In theory, as the cost of capital increases the value of a business or income property (such as commercial real estate and investment properties) will decrease. This is because the increased debt service expense reduces the net income and therefore reduces the amount a buyer would pay for the business or property.
The economic theory behind this is sound, and this tends to be the case with investment properties, but it does not always hold absolutely true. In the Orange County and Los Angeles commercial real estate markets prices have continued to increase steadily in spite of recent interest rate hikes. Likewise, business values have not been affected by recent increases in the prime rate and SBA loan rates. So why is this?
Business value multiples have generally stayed the same as interest rates have gone up and down. Business values are driven more by earnings than the cost of capital. In fact, the cost of capital is a minor factor in most business acquisitions as long is interest rates are in the historically normal ranges. The ultra low rates after the recession of 2007/2008 did not increase business values and now that rates are increasing to normal levels they are not decreasing the value of businesses. It is true that business values did drop after the 2007/2008 recession, but this was a result of decreased earnings, the multiples remained largely the same.
For commercial real estate and investment properties in Southern California prices have continued to increase as a result of high demand and a strong economy in Orange County and Los Angeles.
What is the Effect of a 0.25% Interest Rate Increase on Net Income?
Let’s look at some hard numbers as an example to illustrate why small changes in the Prime Rate and subsequently the SBA lending rate have a minor affect on business value.
Let’s say Steve Smith is considering buying a business for $1,000,000. For this example we’ll assume the business has Discretionary Earnings (DE) of $300,000 which would put the multiple at 2.85X DE (note this is a typical multiple for this size business depending on the industry).
The maximum SBA rate is Prime Plus 2.75%, so we will use the max rate for these examples. We’ll use the SBA minimum down payment of 10%, or $100,000 for maximum leverage which will show the maximum effect of interest rates.
If Steve was considering buying this business in June of 2017, the Prime Rate was 4.25% and the max SBA rate was 7%. The annual debt service would be $125,397 and the net after debt service would be $224,603. That’s a nice return on $100,000 down!
Let’s see how that same business acquisition would look in December 2017 with the Prime rate at 4.5% and the max SBA rate at 7.25%. The annual debt service would be $126,793 – an increase of $1,396 per year, and the net after debt service would be $2223,07. Still a very a nice return on $100,000 down!
So how does it look today with a Prime Rate of 5.25% as of October 2018 and a max SBA rate of 8.0%? The annual debt service would be $133,034 – an increase of $7,637 per year from the June 2017 rates, and the net after debt service would be $216,966. Again a very a nice return on just $100,000 down and this deal still makes sense.
| June 2017 | Dec 2017 | June 2018 | Oct 2018 | |
| Acquisition Price | $1,000,000 | $1,000,000 | $1,000,000 | $1,000,000 |
| Discretionary Earnings | $350,000 | $350,000 | $350,000 | $350,000 |
| Down Payment $ | $100,000 | $100,000 | $100,000 | $100,000 |
| Down Payment % | 10% | 10% | 10% | 10% |
| $ Financed | $900,000 | $900,000 | $900,000 | $900,000 |
| Prime Rate | 4.25% | 4.5% | 5% | 5.25% |
| Max SBA Rate | 7.0% | 7.25% | 7.75% | 8.0 |
| Loan Term | 10 years | 10 years | 10 years | 10 years |
| Annual Debt Service | $125,397 | $126,793 | $129,611 | $133,034 |
| Net After Debt Service | $224,603 | $223,207 | $220,389 | $216,966 |
| Additional Annual Debt Service Cost over June 2017 |
$0 | $1,396 | $4,214 | $7,637 |
At Pacific Business Sales we are experts in transactions with SBA financing and most of our transactions use SBA financing. We have excellent relationships with several SBA PLP (Preferred Lender Program) banks and as your Business Broker we will present your business to our preferred SBA lenders to get a preliminary approval (subject to buyer qualifying). If you are a buyer you can be confident that the SBA financing shown in our Confidential Business Review has been reviewed and approved by our SBA lenders.
