Wet Feet

There are so many things to consider when purchasing a commercial property. In my blogs I highlight dozens of important questions to resolve, I talk a lot about tenants, lawyers, bankers and agents, but one silent assassin for shooting down a property is whether it is subject to flooding.

As you know one of my favourite locations for securing shops at an attractive return is in Queensland. You will have heard the slogan about Queensland – “Beautiful one day, Perfect the next”.

However, many of us also witnessed with shock the January 2011 floods and saw the TV images of cities and towns near a river or watercourse go under water. In fact, the damage on the economy was so devastating the Federal government imposed a Queensland Flood Tax to help get the state back on its feet. So now when I’m buying a property in Queensland, a critical question I ask the agent is “Did the property get Wet Feet in the January 2011 floods?

If a property is prone to flooding or is listed in the council flood zone, then my advice in Engines of Wealth is simple – move on. I’ve sometimes heard agents say “Oh, it did but that was a one in 100-year flood”. The problem however is that it happened twice in 5 years in the case of Queensland. The impact of a flood can be catastrophic, not just the damage caused on the property but on the very survival of your tenant’s business. You see even if the damage on your property was minimal, the mud and debris left by these floods inside and outside the property takes weeks to clean up and at great cost. If the shop gets wet feet the water damage to internal gyprock walls, carpet and electricals results in thousands of dollars and many weeks of repair.

For many tenants, the water damage is not the biggest problem, it is the loss of trade while repairs are carried out and the time for consumer confidence to return that sends them into bankruptcy. As a buyer you need to understand the motivations of the Real Estate agent for a property that is prone to flooding. When asked by prospective buyers if the property floods, to say “Yes it does” means the buyer will run, to say “No it doesn’t” means a potential reporting breach.

Given their job is to sell the property they will quickly move you off the topic, over the years I’ve heard some great responses:

  • “Great question, I don’t think so but let me check with the owner and come back to you”.
  • Their hope is you’ll forget to raise the question again and fall in love with the property
  • “It did back in 2011 but you must understand that was a once in a life time event”
  • “It did get a little bit of water in it but hey it’s the tenants job to clean it up anyway”. Which is not entirely true: electricals, plumbing, roofing, wall integrity is the landlord’s responsibility.
  • “Does it flood? Not to my knowledge.” If an agent did not ask and was never told by the current owners, that the property floods then an agent cannot be accused of telling a lie
  • “It did but the council has done a lot of work to the drains since 2011 to prevent flooding.”

I have even had agents tell me that a property “to the best of their knowledge” hasn’t flooded only to have the tenant tell me it does and the next time it floods they’re not renewing their lease. As mentioned, for many tenants a flood can be a business ending event.

On the question of flooding, you must do your own research on the property and never rely on an agent’s comments.

There are some great websites that make your job a lot easier. If you’re buying a property in under the jurisdiction of the Brisbane City Council, your first point of research is “Floodwise”, see the link: https://www.brisbane.qld.gov.au/planning-building/planning-guidelines-tools/online-tools/floodwise-property-reports

At this site you enter a specific property address and it will highlight if the property is in a flood zone and, it will tell you the minimum and maximum heights above sea level for that specific property. As an example, I was recently looking at a property in Orontes Road, Yeronga, Queensland and was concerned about possible flooding given the properties proximity to the Brisbane River. Typing in the specific address to the Floodwise website in seconds it returned the following report:

 

This graph shows the shop’s land at its lowest point is 6.5 meters above sea level and 8.7 meters above sea level at the highest point on the block. The chart as a reference also shows the level the water reached during the 2011.

Queensland floods at 7.8 meters. Therefore, some parts of the property were quite possibly underwater in 2011. Although this is not conclusive, this report raises alarm bells that require us to keep digging. The next research website I look to judge a property’s propensity to flood, is the council’s online flood maps. A great website is below, select the Flood Maps.

http://floodinformation.brisbane.qld.gov.au/fio/

Once again, typing in the property address Orontes Road, Yeronga produces the following output:

 

The dark blue represents the areas that are most susceptible to flooding and the light blue represents the 1 in 100 year area. Cleary we can see the target property lies firmly within a flood zone and on the edge of the dark blue, this shop has a strong chance of getting wet feet during flood events.

This evidence was enough to halt my interest in this property, however, if the shop had been on the flood fringe, then there is a third website I recommend you investigate. This site shows actual aerial photographs taken during the January 2011 Queensland floods.

https://www.abc.net.au/news/specials/qld-floods/

The website shows an aerial view of Yeronga before the floods:

Using a sliding TAB you drag across to see the aerial photo during the flood:

This site conclusively answers the question “Did the property it get wet feet in the 2011 floods?” I find these pictures really drive home the importance of doing your due diligence around flooding. It would be heart breaking to find the property you own under water.

 

/by

Alarming Deceptions

I have experienced an alarming trend recently in the way agents are under reporting the outgoings for a commercial shop for sale. I think it is false advertising leading to the deception of the unknowing buyer. Real Estate agents are not disclosing the outgoings beyond the standard statutory charges: strata, council and water.  Over 30 years of pursuing property and reviewing several hundred IM Packs the frequency of this deception is increasing!

Unfortunately, I see the problem is most prolific for smaller shops (less than $500,000), where investors are typically less experienced.   Let me explain the impact of this “oversight” on the agent’s behalf with an actual example. For a 50m2 shop in a large strata complex, the Information Memorandum declared the Gross Rent to be $32,500 per annum, with the following outgoings:

Outgoing                                                  Annual Cost

Council Rates                                        $1,250 pa

Water Rates                                           $1,050 pa

Body Corporate                                    $3,600 pa   (Includes the building insurance for a strata shop)

Total Outgoings                                    $5,900 pa

 

If you make an offer at 7.5% return for this property based on the above information you would considers its value to be $355,000 (Gross Rent-Outgoings/0.075).

In Chapter 7 of Engines of Wealth I share the complete list of outgoings that should be captured in the IM Pack, including management fees, maintenance, fire inspection, gardening, grease trap cleaning and rubbish removal if the shop is on Torrens title (i.e. not strata).   One of the key lessons in Engines of Wealth is to establish the true Net Rent position of a building and thus ensure all the outgoings are declared. Do not fall for the agent or owners deception of omitting expenses to artificially inflate the net rent and in turn the building’s value.

When I called the agent and indicated the obvious omissions, he quickly sent the full information and apologised for the “oversight”. In this case, the missing outgoings were:

Management Fee                              $1,520 pa

Air Conditioner Maintenance        $600           (when it occurs, this is part of the landlord obligation)

Land Tax ($80,000 at 1.7%)          $1,360 pa     (this may not apply to you, but the agent doesn’t need to know that)

New Total Outgoings                       $9,380 pa

 

Your 7.5% offer for this shop would now be $308,000. As you can see it makes a HUGE difference.

The practice of routinely omitting outgoings is not as prevalent in the larger transactions, for example neighbourhood centres consisting of 5, 10 or even 15 shops for sale. The reason is because these type of transactions attract buyers that are often experienced investors, hence the agents know that things like administration, cleaning, land tax, fire inspections and repairs and maintenance are costs that must be accounted for.

Again, this is best demonstrated with actual evidence. Below is a recent outgoings audit I commissioned for my neighbourhood centre. This represents the true costs and categories when you own and operate a neighbourhood centre. Note, if you own a single strata shop these are typical of the costs that will appear on the balance sheet of the Body Corporate, which will be allocated based on shop size and appear as a single cost in your quarterly strata invoice.

Outgoing                                                                     Annual Cost

Audit                                                                                  $450

Bank Charges                                                                   $200

Insurance                                                                         $9,500

Cleaning & Gardens                                                       $25,500

Common Electricity                                                      $5,500

Council Rates                                                                  $28,500

Property Management Fee                                          $26,000

Repairs and Maintenance                                            $11,000

Security                                                                            $5,000

Waste Removal                                                               $9,500

Water Rates                                                                      $11,200

Land Tax                                                                           $26,000

Total                                                                                  $158,350

 

To avoid the agents outgoing deceptions always look for the complete list of outgoings. Below is a legend of the typical outgoings that are omitted and what the agent may say to refute there existence.

Administration Fees:      if the agent says “the owner manages the property himself so he doesn’t incur those charges.” Your reply is “I’ll be using an agent and have factored in a 3.5% management fee”.

Waste Removal: if the agent say’s “The tenants looks after their own rubbish.” Your reply, “OK I’ll go to the shop and ask the tenant about that”.

Cleaning: when the agent say’s “The tenant keeps the place tidy and does the gardening so there’s not much cleaning required.” Again, you should check with the tenant and understand what cleaning and gardening is required or done on a regular basis.

Fire Inspections: agents will tell you “The owner hasn’t called these out so I’m not sure if there required.” My strong reply is something like “Fire inspections are a mandatory requirement by law, please ask the owner when was the last inspection and tell them that I will add $500 to the annual outgoings”.

Repairs & Maintenance: agents will say “There is no allowance as it is a well-built shop and nothing requires repair.” For a small shop there is always something that needs to be fixed each year, so I would assume $1-2,000 for repairs and maintenance. Tell the agent that is what you have deducted from the Net Rent.

Land Tax: agents will always say “Land Tax does not apply to this property and has therefore been omitted as the land value is below the land tax threshold of $600,000.” The catch here is that this figure is cumulative! If you have 2, 3 or 4 properties within the same state in your name, commercial or residential, you may exceed the threshold, in which case land tax will be payable on this property. When negotiating I always inform the agent “that I own other properties and hence will be paying land tax, therefore I will deduct the land tax off the net rent and base my offer on that.”

Audits: the Retail Lease’s Act requires a landlord to provide the tenant an independent audit of the shops outgoings if they are being passed onto the tenants. The cost of this will be from $300 up to $1,000 for a larger centre. You should ask the agent for a copy of the last audited outgoings statement, if he doesn’t have it ask the tenant if they get one as required by law.

/by

The Lease Renewal

One of the most important activities you will undertake while owning and operating a commercial retail property is renewing the lease upon expiry. The key is to be prepared and to be ready to act early, preventing an extended vacancy if the tenant chooses to leave the shop.

One thing I have found is that sending a request to the tenant three months prior to the lease expiration is simply not long enough in the event they decide not to renew. Yet this notice period is a common clause in many leases. When a tenant does inform you they will not be renewing their lease 3 months prior to expiry, you are suddenly on an accelerated timeline to find another tenant and avoid the loss of rent.

You will first need to select and appoint a letting agent, work with them to design and post an ad online, select and interview a prospective tenant, organise lease disclosure documents and a new lease and then allow time for the tenant’s lawyer to review and execute it. As you can see this is a lot in just three months, my experience is sourcing a new tenant takes up to 6 months. As a landlord every week the shop is empty means loosing precious rent. The other critical factor when changing tenants is the expected rent-free period for the incoming tenant to undertake their shop fitout works.

My recommendation, you need to confirm your expiring leases early, at least 6 months prior to their expiry. A standard clause I insert in all my leases is that the tenant must notify me of their intention to re-let the shop 6 months prior to expiry. In doing so you have time to avoid potential rent loss from vacancies.

The flip-side to a tenant departure is a lease renewal. If the tenant exercises an option within their lease to extend it may specify the allowable rental increase. However, in most cases when exercising options and lease expiries the landlord will be allowed to “market adjust” the rent. It is essential that you are equally prepared for this discussion.

A prudent practice when approaching a lease renewal is gaining an understanding of the rental market and typical floor space rates being achieved in that area. The best way to do this is to call 2-3 local real estate agents and ask them what properties they have recently let and what rents were achieved. I have always found these agents to be helpful and responsive, because in the event your tenant doesn’t renew their lease, you will be approaching them to find you a new tenant. So it is in their interest to assist you.

Another idea to assess the market rents is to study the online websites and local paper to see what’s on the market for lease. After doing your research you will have built a reasonable knowledge of what rent your shop should secure. You need to document the proposed rent increase citing your sources as evidence. Once the tenant receives your rent proposal for the forthcoming lease term, be prepared for some objections, some tenants will to tell you:

  • “Business is slow”
  • “The internet and online shopping has reduced their turnover”
  • “The centre is not as busy as it used to be”
  • “I’m just not making the same margins I used to”
  • “There’s an opportunity to move up the road on half the rent”
  • “My staff costs and expenses have gone up, it’s not worth my while if you put the rent up”

It is the tenant’s objective to convince you they are going broke and are about to shut their doors, just so you don’t put the rent up. They will probably argue that the rent should be reduced. I hear this often and it is expected behaviour for a shop keeper to want to keep more of the profit for themselves. Your mission is to ensure the rent your shop is deriving remains current with what the wider market is returning.

My approach for the rent increase discussions is to start by letting the tenant know that they are coming off a 2, 3 or 5 year lease so the market has moved since they negotiated the previous lease. Market rents have climbed faster than CPI or the fixed increases built into their lease. I inform them that this renewal will be a market adjustment where we need to ensure the rent has kept pace with the increasing costs of council rates, water rates, insurances, bank interest and labour cost for cleaning, gardening and management.

The tenant will not like it, but your preparation and documented evidence of rental floor space rates of similar shops in the area is a huge pacifier to get the tenant to accept the increase. I generally find market adjustment increases of 4 – 5% are readily accepted by the tenant.

In the occasional situations where you find rents have increased significantly and equate to increases of 10 – 15%, these situations can lead to difficult conversations and hence require more preparation. It is always a negotiation and whilst you can hold your ground and demand the increase the tenant can also look elsewhere and exit leaving you a vacant shop. It is always a good idea to be fair and look for compromise in these situations. For example, to moderate the impact you may consider not passing this large increase upfront, instead staggering the increase as 5-7% for each of the next two years.

This situation often occurs when I offer tenants a low rent deal to fill a vacancy or secure their specific business type in my centre. In these situations, I inform the incoming tenant they are below market and attempt to apply a 4% annual increase in their lease. However, at the end of lease there are still situations where their rent is lagging the market.

In considering alternate, palatable options for a tenant’s rental increase the other variable you have in the lease is to increase the renewal term. In short, a longer lease effectively fixes the rent and annual increases for a longer period. If the tenant is coming off a 3 year lease they will have a good knowledge of their businesses performance and developed a level of comfort around their turnover. Deciding to sign a 5 year lease with 4 or 5% annual increases minimises the impact of a large rental correction and protects them from another market adjustment for 5 years. I have typically found that tenants who lock their rents in for 5, 7 or even 10 year terms enjoy cheaper than market rent in the later years of the lease.

In summary, the key points when approaching a lease expiry are:

  • Get to it early, 6 months before expiry
  • Put it in your lease that the tenant must exercise their option 6 months prior to expiry
  • Secure an agent and advertise straight away if the current tenant is undecided at the 6 month mark
  • Do your research on market rents in the local area
  • Review your expenses and be ready to let the tenant know which ones have increased and by how much
  • Use it as an opportunity to apply a 5% annual rent increase
  • Use it as an opportunity to extend the lease term.
/by

The Cost Of Quality

I sometimes come across a property that seems perfect, the right location and tenant, it is the definition of strength and quality. These are the properties that tick all the boxes and scream out “Buy Me!”.

In Engines of Wealth we dedicate an entire chapter to defining the characteristics of a great retail shop, so you can recognise them when you see it. It could be the café positioned opposite Bondi Beach or a newsagency in Flinders Street station. The best sign to indicate a shops’ quality is a national brand, such as Bakers Delight, Boost, IGA, Subway, Coffee Club or if your pockets are deep enough Bunnings.

The above businesses all make great tenants with an exceptional ability to pay their rent, offering you the landlord security and safety. The question is what is the price to pay for such quality? No matter how attractive they seem I typically find these “perfect” shops to be too expensive, with capitalisation rates of 6% or less.

I am regularly asked the question “Phil, at what capitalisation rate do you see quality, how low are you prepared to go?” and also “What are the risks of going too far?”. Those who have read Engines of Wealth will know that the simple mathematic formula I use to guide my purchasing decisions and value properties should deliver the investor a 7.5% rate of return. With Australian interest rates at low levels, this return offers the buyer a solid profit and a reasonable safety margin against interest rates that will one day edge upwards.

I use a 7.5% return as the foundation for a strong investment, I have been known to increase my price when I believe the shop has something special. In short, I am willing to pay a premium for quality, yielding a lower initial return. I don’t think there is a better example to use to demonstrate quality than a Bunnings Warehouse, but just how much is that quality worth?

Let me expand on my thought process to understand the implication of this question. At the end of 2018, I can secure a bank loan to buy a shop for 4.5-4.6%, so with returns of 7.5% and above this offers a reasonable safety margin for profit. Paying higher prices and achieving lower returns of 7% or even 6.5% for quality properties is something I would consider. However at 6.5% I remind myself of a golden rule “we invest to make money”, we don’t invest to drive past the property each week and feel proud we own it.

The shops on realcommercial.com.au with national chain tenants are often listed with capitalisation rates of 5.0 – 6.0% return. In some cases these properties have development potential from a rezoning aspect that justifies the price point, but in most other cases I’m left shaking my head. When I see properties selling for 5.0% – 6.0% returns I am never disappointed I missed out on the sale, at that price I’d rather walk away. I believe the people that buy at such low returns are not impacted by banks and interest rates, they have the cash in the bank and want to convert it into a strong, resilient income stream. After all if you have the money, 5% in a strong shop is still better than 2.5% in a bank term deposit. Like most investors, I do not have this luxury and borrow money to secure my shop, hence need to ensure my returns stay well above the bank interest rate.

So back to our Bunnings example, what price is quality worth? I recently came across a Bunnings for sale in Katoomba in the Blue Mountains, normally I do not see value in NSW, but given this is in a growing regional area I was interested. The energetic agent shared some recent Bunnings Warehouse sales statistics to help encourage me that the Katoomba property was good value. I was truly amazed at these sales results and have attached them below to emphasise what others believe is the price for a quality Bunnings Warehouse.

engines-of-wealth-book

Upon first look a few things jump out, like what was the WA buyer in Osborne Park thinking at a 4.65% return? When you get your head around the 5-5.5% returns, next is the sheer size of some of these transactions – $25M, $30M and Caringbah at a touch under $60M. Wow these transactions are certainly the big end of town and this is why I don’t own a Bunnings, but we can always dream of having this much money to deploy.

If you have this sort of money in the bank, then getting a 5.5% return, plus capital growth of 2 – 3% results in a decent 8% return which is tax effective after depreciation. For the rest of us that rely on bank funding to fuel our investments then these capitalisation rates should be avoided. My advice is when an agent offers “similar sales figures”, remember they are trying to convince you that everyone is getting this return, so you should be happy as well. In my experience I strive to be a better investor than most and will not be influenced by ‘herd mentality’. There is no such thing as safety of the pack when you are investing, you hunt alone and every shop is different – even with a national brand on the door.

When looking at a property that looks “perfect”, each investor must understand their personal situation and not over stretch your ability to meet mortgage repayments. I like the 7.5% valuation as it provides a good safety margin and I believe there is a natural level in the economy in which it would be difficult for interest rates to exceed. Aggressively acquiring quality properties at capitalisation rates below 6.0% is only a good idea if you are paying cash.

I sometimes try to “separate from the pack” and pursue the prize of a café on the beach or a Woolworths, but one thing always holds true, I cannot predict interest rate movements so the Cost of Quality is always above a 6.5% rate of return. Which means for now the dream of owning one of these big fish must wait for the market to return to “buyers conditions”.

/by

Engines Of Wealth Are In The St George & The Sutherland Shire Leader!

,

We are thrilled to be featured in todays edition of the St George & Sutherland Shire Leader!

We were recently interviewed by The Leader regarding our book and thoughts on the Australian property market.

As the title states, we believe that you shouldn’t give up on your home ownership dream! You just need to rethink your investment strategy.

Our book outlines the steps we took to building financial wealth and security. We go into explicit detail on how you too can build this wealth and positive income stream for yourself!

To read the full interview CLICK HERE >

To get a copy of our book Engines Of Wealth CLICK HERE > 

For One-On-One Consulting or Buyer Agent Services please CLICK HERE > 

/by

Commercial Real Estate – A Way To Eventually Own Your Own Home

We were recently interview by The Leader and questioned about our views on commercial real estate and first home ownership in Sydney. In recent years Sydney property prices have sky rocketed. This has resulted in a lot of first home buyers unable to get into the market. 

Read more
/by

Air Conditioners

, ,

One of the key reasons we selected commercial retail shops as the foundation of our wealth engine was due to the low maintenance aspect of these shops. In fact the only real major items of plant and equipment that is the responsibility of the landlord to fix is the hot water system and the air conditioner. The hot water systems are typically not that expensive at around $1,000 installed and will last between 8-10 years. So whilst it’s a good idea to understand how old the hot water system is it typically won’t be a factor in your property due diligence. Read more

/by

Dangers of Short Lease Terms

, ,

One of the key things I like to see when buying a retail shop is a long lease. Not only does a long lease offer you security over future rental payments it wins the banks confidence in the asset as it presents with a higher WALE (Weighted Average Lease Expiry). In Engines of Wealth we discuss the WALE of a building as a measure of the lease term left to run. Read more

/by

The Value of Depreciation

, ,

In my opinion Depreciation is the secret sauce when selecting retail shops as our wealth building engine. Our wealth building strategy is to create a long lasting income stream that is indexed to inflation and tax effective. Read more

/by

Guarantors

, ,

A guarantor must be identified on the tenant’s lease, it could be the tenant or a friend/relative. A guarantor should be a person that has suitable assets to provide security over future rental payments. The subject of a guarantor is not only an important consideration at the time of purchasing a property, it is also important when a tenant has decided to sell their business or assign the lease to another party. Read more

/by