The Car and Truck Fleet and Leasing Management Magazine

Residual Value Trends and Forecast

June 2005, by Raj Sundaram

At a macro-economic level, three indicators that are most important for determining used-vehicle prices include: wage growth to predict consumer demand, net new-vehicle prices to forecast competitive vehicle demand, and used-vehicle supply.Wage growth is the most reliable indicator of used-vehicle demand. GDP growth, business investment, and unemployment are also important factors to examine, as job growth predictors. These (indirect) drivers help stimulate demand for labor, which also eventually stimulates wage growth. Without wage growth though, there is little chance for used-vehicle prices to change as rising wages tend to drive consumers to spend more in the medium to long run.That being said, the current predictions for demand-side growth are fairly low to neutral. Although GDP growth and unemployment movements have been positive for the economy in 2004 and moving into the near future, their effects have barely stimulated wage growth enough to keep pace with inflation. Compared to previous economic recoveries, this has been one of the worst for real wage growth. Even with a strong economy and real jobs growth, there has not been much real-term wage growth (Figure 1). Figure 1. Wage growth is the most reliable indicator of used-vehicle demand. GDP growth, business investments, and unemployment are also important factors to examine, as job growth predictors. These (indirect) drivers help stimulate demand for labor, which also eventually stimulates wage growth. Without wage growth though, there is little chance for used-vehicle prices to change as rising wages tend to drive consumers to spend more in the medium to long run. Even with a strong economy and real jobs growth, there has not been much real-term wage growth. Rising interest rates are often used as a predictor of inflation. In the used-vehicle market, the opposite is true, as mounting interest rates are also a sign new-vehicle incentives will rise, which will further lower net new-vehicle prices. The Effect of Incentives
Because manufacturers control the decision to absorb or pass on interest rate movements to the consumer through the use of incentives in a big way, interest rates can often act contrarily to normal market thinking. In effect, the current predictions for new-vehicle prices are around 1-2-percent decline per year for the next 4-5 years because of the unprecedented increasing levels of incentives (Figure 2).Figure 2. The current predictions for new-vehicle prices are around 1-2 percent decline per year for the next 4-5 years because of the unprecedented increasing levels of incentives. This trend of rising incentives is predicted to continue, given the forecasted increase in sales over the next few years. Incentives current average is around $3,123 per vehicle, and in 2005, they are predicted to rise to $3,591 per vehicle. This trend of rising incentives is predicted to continue, given the forecasted increase in sales over the next few years. Incentives current average is around $3,123 per vehicle, and in 2005, they are predicted to rise to $3,591 per vehicle. Although foreign nameplate vehicles are not immune to the incentive-sclerosis that has maligned the industry for the past several years, since 2002, domestic brands are, on average, $2,300 higher per vehicle compared to import brands, which are up on average around $900 (Figure 3). Figure 3. Although foreign nameplate vehicles are not immune to the incentive-sclerosis that has maligned the industry for the past several years, since 2002, domestic brands are, on average, $2,300 higher per vehicle compared to import brands, which are up on average around $900.Figure 4. The only positive for used-vehicle values is the declining supply of used vehicles. Used-vehicle supply is currently showing a net decline this year, and this trend will continue to strengthen significantly into 2007. This is primarily driven by the decline in leasing over the past few years. The only positive for used-vehicle values is the declining supply of used vehicles. Used-vehicle supply is currently showing a net decline this year, and this trend will continue to strengthen significantly into 2007. This is primarily driven by the decline in leasing over the past few years (Figures 4 and 5).In 2008, used-vehicle supply will increase again as current production levels are predicted to rise from 16.8 million this year up to 18.0 million by 2007. Leasing is also rising from a low in 2003 of 1.8 million vehicles to 2.4 million estimated for 2005.What does all this mean for used-vehicle prices? Real wages are not very strong right now nor will they be in the near future, and this is important for predicting consumer demand. Net new-vehicle prices are predicted to continue declining at a steady 1-2-percent rate for the next 4-5 years. The one positive is in the decline of used-vehicle supply for the next three years. Although 2004 showed mild volatility in prices (Figure 6) with gains in the first half of the year evaporating in the second half, year-to-date prices are up around 1 percent. Automotive Lease Guide’s (ALG) prediction for the next three years is up 1.25 percent for 2005, 0.75 percent for 2006 and -1 percent for 2007. Brand Strategy - Critical Success Factors
ALG has identified four main areas that need to be managed successfully to create positive resale value. Used-vehicle supply management:
Realistic volume goals will be important to minimize pricing risk as future residual forecasts take into account the impacts of supply.MSRP/incentive strategy:
High incentive strategy will continue to have a negative impact on residuals. The type of incentive will also be important in determining the residual impact, i.e., customer cash vs. lease subvention.

Remarketing:
Remarketing programs continue to have a strong, positive correlation with residuals. In addition, evidence indicates that a strong remarketing strategy will reduce return rates.Brand perception:
Perceived, not actual, quality has the strongest correlation with residuals at the brand level. High fleet incentives and other factors can materially deteriorate a brand’s image and will be a critical factor for new-model launches. Negative Pricing
ALG forecasts 1-2-percent negative pricing in the industry over the next few years. ALG does not believe that an improving economy can help both sales and pricing. Luxury pricing will also be negatively impacted as the Housing Price Index (HPI) growth is expected to slow. Figure 5. In 2008, used supply will increase again as current production levels are predicted to rise from 16.8 million this year up to 18 million by 2007. Leasing is also rising from a low in 2003 of 1.8 million vehicles to 2.4 million estimated for 2005.Value/market-based pricing strategies will maximize residuals. The 2005-model year will test the high MSRP - high incentive approach.Impact of Remarketing
ALG forecasts return rates to drop eight points this year compared with last year and drop another five points in 2005.Remarketing will be more integrated into new-vehicle marketing/sales especially within luxury/niche brands as more companies realize the impact of remarketing on residuals. Figure 6. Net new-vehicle prices are predicted to continue declining at a steady 1-2 percent rate for the next 4-5 years. The one positive is in the dcline of used-vehicle supply for the next three years. Although 2004 Showed mild volatility in prices with gains in th efirst half of the year evaporating in hte second half, yar-to-date prices are up around 1 percent. Residual Outlook
Despite the near-term decline in used-vehicle supply and improving economic conditions, the new-vehicle pricing environment will keep the pressure on residuals.ALG forecasts used-vehicle prices will rise about 1 percent in the next two years and start declining in 2007. ALG forecasts mid-premium luxury, minivans, full-size SUV, sporty and mid-size car residual values will decline at a faster rate than the industry average. Wage growth and wealth effects are key indicators that drive inflation in resale values from a macro standpoint and incentives/net pricing will be the critical driver for residuals in the next few years from an industry-specific standpoint.Brands that can minimize the use of incentives while achieving sales growth will experience relative strength in residuals. Domestic brands will have to capitalize on the 2005/06-model year to bridge the gap and improve on the prior model-year performance. Raj Sundaram joined Automotive Lease Guide (ALG) in 1999, where he is responsible for overseeing the analytical and day-to-day operations of ALG in the U.S. and Canada. He graduated from Lehigh University, in Bethlehem, Pa., with an MBA in finance and has a BS and MS in accounting from the University of Bombay, India. He lives in Santa Barbara with his wife and two sons.
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