Peaks and troughs: The residual value roller coaster

From steep drops to huge hills, residual values have been on a roller coaster ride during the past year as retention values on used cars plummeted in the first half of 2020 during the COVID-19 pandemic, then climbed to new heights in the latter half of the year and into 2021. Last year, pandemic-related lockdowns, auction closures and a dip in vehicle demand led to a substantial decline in vehicle values, and in residuals, Jonathan Smoke , chief economist at Cox Automotive told Auto Finance News . However, toward the end of 2020, used-vehicle prices began to increase, residual values began to recover, and vehicle sales rebounded. “We started 2021 with demand stimulated as strong as you could possibly have imagined,” Smoke said. “And yet, we have extremely tight supply that has actually gotten tighter because of production challenges in the new vehicle market.” As a result, vehicle values have reached record heights, setting a new baseline for what is considered “normal.” Climbing the residual hill The auto finance industry is likely to see years of heightened retention values due to the pandemic, setting the stage for how lending trends might change. Vehicle values have been increasing about 1% to 2% per week as of April 2021, said Eric Ibara , director of residual value consulting at Kelley Blue Book . Looking back, used-vehicle prices in March 2021 increased 5.9% from February, bringing the Manheim Used Vehicle Value Index to 179.2, a 26.2% increase from a year ago. Retention values for cars 1 to 3 years old exceeded 70% in March 2021, an increase of 12 percentage points year over year, Smoke said. “Higher values have translated into previously unthinkable retention values, and we haven’t seen the peak yet,” Smoke noted, adding that unprecedented demand for used and new cars, along with record low supply, continues to drive up prices. New-vehicle inventory levels were down 22% YoY in March 2021 at 2.7 million units, with an average of 71 days’ supply said Charlie Chesbrough , senior economist at Cox Automotive . Constricted supply has not slowed consumer demand. In fact, used-vehicle sales increased 117% YoY in March, bringing the used retail SAAR to an estimated 22.2 million units, up from 20.8 million in February and up from 9.8 million from March 2020, according to Cox Auto. Total new-vehicle sales also increased 59.7% YoY, factoring one more selling day. The new retail SAAR was estimated at 16.4 million, up from 8.4 million in March 2020, when sales plummeted due to pandemic-related closures. Increased sales in the new- and used-vehicle market continues to drive up vehicle prices, Ibara noted. “It’s kind of a perfect storm for wholesale values,” he said. As vehicle values rise, auto lenders are also starting to loosen their credit standards to near pre-pandemic levels, Ibara added. “I think we're in the early stages right now of lenders feeling more confident about the future, about loan performance and about the staying power of the increase that we've seen in vehicle values,” he said. “We are starting to see more [OEMs] advertise lease programs with attractive payments.” Rising values also had a positive impact on recovery rates. Consumer Portfolio Services ’ recovery rate, for one, rose 8.8% YoY in Q4 2020 to 41.9%, according to the lender’s earnings supplement. At Citizens Bank , gross recoveries jumped $2 million YoY in Q1 2021 to $14 million, according to the bank’s earnings presentation. Vehicle price appreciation is likely to continue at least through June before it begins to level off, Smoke said. The ongoing microchip shortage that is contributing to new-vehicle supply shortages along with lower repossession volume are driving up used-vehicle wholesale prices in 2021, said Alex Yurchenko , vice president of data science at Black Book . “Short-term, we’re looking at record week-over-week increases,” he said. “Overall, 2021 seems to be good for wholesale prices. I don’t see any big changes in the market that will change those dynamics.” While used-car value increases are typical in the spring, the increases felt so far this year are “extraordinary” and are likely to continue through at least the second quarter, Kelley Blue Book’s Ibara added. “We thought last year was volatile, but this year is shaping up to be just as volatile as last year was,” he said. “And it's coming at a time when we thought everything was going to be settling down again.” Peaks and troughs This time a year ago, many auto lenders could not have predicted the unprecedented increase in vehicle values that has marked the beginning of 2021. When dealerships and auctions closed in April 2020, wholesale prices plummeted to a three-year low, bringing the Manheim Used Vehicle Value Index to 125.8, a decline of 9.2% YoY and 11.4% from the prior month. Price depreciations affected all major segments, with the used retail SAAR dropping in April 2020 to 14.1 million units from 17.3 million units in March 2020. That drop in vehicle values was in part driven by an oversupply of used vehicles and stalled vehicle sales amid a dip in market demand during the early months of the pandemic. BMW AG and Honda , for example, suspended manufacturing at several plants in March 2020 as demand fell. By the end of April 2020, used retail supply sat at 53 days compared with the normal 44. “Last year, we had a roller coaster ride on residual values,” Cox Auto’s Smoke said. “In the early parts of the pandemic, especially during the lockdown period, we saw a substantial decline in vehicle values, which translated into residuals declining. The latter half of the spring, into the summer, we went through an unprecedented period of price appreciation, which more than recovered the loss in residuals and actually delivered a peak increase year over year.” In May 2020, vehicle prices again began rising as supply dwindled due to pent-up consumer demand. The Manheim Index not only surpassed pre-pandemic levels, but climbed to record heights in June, July and August 2020 before leveling off at 161.2 in September. Retention rates also started to dip in April 2020, falling to about 56% in May and June, but ended at about 62% by yearend, Smoke said. By March 2021, retention rates exceeded 70%. The pandemic also led to lower-than-average incentive spend on new vehicles, which generally helps push consumers into that market. Incentive spending is expected to land around 8.5% to 9% of manufacturer's suggested retail price in 2021 from the normal 10% rate, said Kristen Lanzavecchia , senior manager of industry insights at JD Power . In April 2021, the average incentive spend of $3,102 was down 27.8% from a year ago — the lowest point since April 2016 — driven by tight supply and strong vehicle demand, according to TrueCar . “A combination of both supply shortages and low incentives helped to lift used-car values last year, and we've really seen that trend continue in the beginning of 2021,” Lanzavecchia said. Prices are still increasing. The Manheim Index reached 191.4 in April 2021, another all-time high. End of the ride? Vehicle values are expected to smooth out by the end of 2021, but are unlikely to drop back to pre-pandemic levels, Cox Auto’s Smoke said, noting that increased values are likely to impact the industry for years to come. “If you ignore where you've been, and you focus on where you're going to be at the end of June [2021], it's more likely you can predict what's going to happen in July, August, September,” Smoke added. “But it's still going to look like a huge increase relative to prior years because of what we've gone through in the prior 12 months of these incredible increases.” A dip in leasing will also contribute to declines in the used-vehicle supply, and related value increases, during the next two to three years, JD Power’s Lanzavecchia said. Leasing share fell to about 26% in Q4 2020, from the normal 30%, largely due to OEMs prioritizing retail channels amid high demand, according to Experian . “In 2023 and 2024 is really when we’ll see the biggest dip in used supply, which will have a positive impact on residual values for vehicles that were sold either last year or this year, and will return two or three years from now,” Lanzavecchia said. At the same time, tight supply and higher wholesale values are impacting the economy in ways not foreseen when COVID-19 shutdowns were first initiated, Kelley Blue Book’s Ibara said. It is yet unclear exactly how long values will remain elevated or where they will level off. “I think [the pandemic] will have a wider impact that we have not seen play out yet,” Ibara said. “It'll probably take years for us to realize how much this has impacted the industry.”

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