Insurance – Do I need it?

One of the most frequently asked questions I get from prospective shop owners is around the owner’s responsibility regarding building and public liability insurance. They include:

 

  • Should I insure a property the moment I sign the contract?
  • Should I wait until settlement, in case the vendor already has it insured?
  • What are my legal obligations?

 

The Engines of Wealth team are pleased to provide answers to these burning questions from an industry expert, Sean Bemrose, Managing Director of Tony Bemrose Insurance Brokers (TBIB). As current or future owners of commercial retail shops you need to be aware of your rights and potential risk exposure when it comes to building and public liability insurance.

 

Let us start with the buyer’s responsibility for building insurance on a new shop purchase. Most understand that building insurance is needed after settlement, but what about pre-settlement? For Queensland properties the buyer assumes legal liability and responsibility for the property from 5pm on the next business day after signing the Contract of Sale for a property. This is defined in QLD Property law (Act 1974) and outlined in the standard terms of the REIQ Contract of Sale. Note, this timing differs in other states, so you need to check the contract. This timing indicates the start of the buyer’s risk and the reduction of the seller’s responsibility for the property.

 

Now the area of contention comes if the property is damaged between the date the contract goes unconditional and final settlement. Many are surprised to know that in this period the seller is not liable to damages, it is the buyer! Note, in this situation the buyer cannot pull out of the purchase of the property nor can they seek to reduce the contract price. Furthermore, the buyer is potentially liable to pay compensation to an injured third party should they be injured on the property.

 

Shaun Bemrose shared a few experiences where the property being purchased was damaged by a fire or storm event before settlement of the contract. In these cases, his clients had arranged building insurance on the signing of the contract, thus providing risk coverage for the buyers to cover the property repairs and legal costs. Given settlement can take months to finalise, this is a reassuring policy to have.

 

The next item of potential risk for the buyer is relating to public liability claims. Your risk and exposure begins from the day you sign the contract of sale until you sell the property, many years later. Now most of us assume that the tenant has their own public liability insurance, in most cases this is mandated in their lease. The buyer during the contracting period and after settlement is also exposed to public liability claims where a tenant or occupant of the property is injured at the property. Note such liability could be greater than the value of the property to be purchased, so insurance is highly recommended.

 

Digging deeper into the nuances of liability, some may feel at ease given their commercial shops are part of a strata. They believe the Body Corporate insurance plus the tenant’s liability insurance policy provides them with full insurance protection against liability claims. However, the law indicates that an injured third party can seek compensation from any party which may be connected to the property and injury event. That is the tenant, seller or buyer.

 

 

The Body Corporate would as a rule have in place property and public liability insurance that covers the building and all common areas of the property, eg. walkways and toilets. It is a standard commercial leasing requirement for the tenant to take out public liability insurance and glass insurance for the shop’s internal areas. The landlord should sight this insurance policy and have on file the tenant’s insurance certificate of currency. Also, the owner should be listed on the tenant’s policy as an interested party to maximise their coverage. For most situations of injury, the buyer is covered, but there are cases where the buyer is not coverage and should therefore have his or her own policy.

 

If a circumstance arises where a third party is injured in the shop and that injury arose from flooring, plumbing, air conditioner or an electrical connection supplied by the owner, then the current landlord or buyer may be the subject of a legal lawsuit for damages – not the tenant. Landlord’s public liability insurance would cover any legal costs incurred responding to a claim, payment of a legal defence and potentially cover the payment of any compensation awarded to the injured party.

 

Another situation is if the shop becomes vacant, obviously the landlord loses the protection of a tenant’s liability insurance cover after they depart. The only way for a shop owner to mitigate this risk is to take out a liability insurance policy in their name.

 

Most REIQ leases provide a legal obligation that the tenant takeout public liability insurance, this may have lapsed or not be present when you settle. As the shop purchaser and future owner, it is wise to take out insurance to protect your interest from the date you sign the Contract of Sale. Remember, in most cases the owner’s insurance costs become an outgoing and can be passed onto the tenant, so why wouldn’t you have it?

 

With all of this in mind, the most important takeaways are;

  • Under Queensland Law, from the date you sign the contract you have a legal liability for that property and,
  • Insurance for the property should be taken out on the date you sign the contract
  • You need your own Public Liability Insurance regardless of the fact the tenant also has a public liability policy

 

Personally, I use Tony Bemrose Insurance Brokers (TBIB) to cover my properties and can thoroughly recommend them, if you need advice on your insurance needs contact Tony Bemrose Insurance Brokers on:

 

Phone:  07 3252 5254

Email:    www.tbib.com.au

 

 

Special thanks to Sean Bemrose Managing Director TBIB for his insights on this subject and for the outstanding support he has provided our Engines of Wealth customers.

 

 

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TO BE OR NOT TO BE, GST REGISTERED?

There are several questions I am often asked as a long-term owner of retail shops:

 

  1. Will GST be applied to the purchase of a commercial property?
  2. Should I be registered for GST?
  3. Will I need to charge my tenant GST on their rent and outgoings?

 

The source of my reply comes from many conversations I have had with my accountant, Ian Marsh[1]. I have summarised our discussions on the requirement to be registered for GST for a particular transaction:

 

The application of GST is dependent upon the vendor selling the shop. If the owner is currently registered for GST and has been charging the tenant GST in the monthly invoices, then GST is applicable on the sale of the shop. In this case you, as the buyer, are required to be registered for GST. Now there is a twist, hypothetically the owner selling the property to you would charge you GST, you would pay the GST on settlement and then claim it back on your BAS statement, sort of pointless right? Well the Government acknowledges this pointless transaction and hence allows an asset to be sold as “The Supply of A Going Concern”, thus negating the need to charge and claim back GST on the sale.

 

The indicator that the current owner is registered and charging GST is in the Contract of Sale, the seller will have ticked the box “Sold as a Going Concern”. If the seller has ticked this box they are declaring that they are registered for GST and have been charging GST to the tenant. Another idea is to check with the tenant directly, call them and ask if they have been paying GST on their monthly invoice. Your solicitor will also tell you if GST is applicable to the transaction and what GST status the seller has indicated on the contract of sale.

 

For you to avoid paying GST on the sale of the property and benefit from the Government’s GST exemption on the “The Supply of a Going Concern”, you also need to be registered for GST. To do that you will need to have an Australian Business Number (ABN) and ensure that ABN is registered for GST. My advice here is to contact your accountant and review the purchase with them, if you don’t already have an ABN your accountant can easily request one and register it for GST.

 

Like most things tax related, there is another twist. You may have heard that if the rent collected from all your commercial properties is less than $75,000 per year, then you are not required to register for GST. Thus, saving you the hassle of preparing and submitting a quarterly BAS statement. Well, unfortunately this threshold doesn’t apply if the seller you are buying the property from is already registered for GST and has been charging GST. In that situation you need to also be registered for GST to avoid paying GST on the sale, unfortunately once you are registered for GST there’s no going back, you need to charge GST to the tenant and submit a quarterly BAS statement moving forward.

 

The other point to understand is the $75,000 threshold is cumulative, it’s not per shop. If the sum of the annual rents from all of your properties is less than $75,000 per year, then you may not be required to be registered for GST in the situation where the seller is not GST registered. In the case where the seller and buyer are not required to be registered for GST and the rent collected is less than $75,000 per year, the transaction is deemed to be GST free and this should be noted on the Contract of Sale.

 

It is also important to note that the Australian Tax Act requires you to have a formal agreement in place between the Seller and Purchaser, signed by both parties clearly stating that the transaction is the supply of a going concern and GST free. This agreement is required in addition to the Contract of Sale.

 

Now as we mention in our book, Engines of Wealth -Commercial Retail Shops, we do not like buying properties that are vacant. If one was to buy a vacant property then under the Governments definitions it would not be considered “The Supply of a Going Concern” and GST would be applicable to the sale. The reason for this is that there is no current lease in place for the property.

 

The key message here is that It is critical to check with your solicitor on the GST status of the seller and what they have marked in relation to GST in the Contract of Sale, then review that advice with your accountant. At present the GST rate is 10%, so on a $500,000 property this equates to $50,000, a sizeable amount for an investor. You need to be extremely diligent and ensure your accountant and solicitor advise you on the GST status of a property transaction, it could save you thousands of dollars.

 

[1] It should be noted that the purpose of this article is not to provide you financial advice but merely to highlight the key points you should discuss with your solicitor and accountant in relation to GST and purchasing a property.

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FOR THE TIMES THEY ARE A CHANGING

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Last week the Engines of Wealth team achieved a milestone that I believe is a sign of the changing times, we assisted Valma secure her first commercial property investment. What makes this notable is her tender age of 85 years young. This sale is not a one-off occurrence, prior to that we had helped Kathy, 72 years old and Rod 83 years old secure their first retail shop investments, but at 85 years, Valma takes the trophy.

Most people’s vision for retirement involves simplifying their life with a modest home and lifestyle. Like Valma, for many Baby Boomers and previous generation, the plan was to retire with a lump sum of cash, deposit it into a bank term deposit at 5-6% and live off the interest. The problem for many retirees is that this plan no longer works in today’s economic environment. Plummeting interest rates have impacted term deposits to the point that returns have become untenable, forcing retirees to look in radically new directions to survive.

The story of Michelle is an increasingly common example, Michelle owns her modest 2-bedroom unit outright and retired 8 years ago with a lump sum of $600,000. She invested this nest egg in a term deposit in the bank. In 2011, Michelle was able to invest her money for 12 months at 6.15%. Her $600,000 generated ($600,000 x 6.15%) $36,900 per year or $709 per week. Michelle’s money in 2011 supported her basic lifestyle, this was 50% higher than those retirees surviving on the single pension in 2011. This approach was, and still is, the retirement strategy for many older Australians.

Rolling forward to 2019 and something serious has gone wrong with this strategy – the bottom has fallen out of interest rates. The Reserve Bank of Australia on Oct 1, 2019 lowered the official cash rate to 0.75%, the lowest level ever in Australia’s history! Adding to the woes is that all messaging coming out of the RBA is that interest rates will continue to fall, so there is no upside in sight for Michelle and others like her. The best deposit rate I found for retirees’ lump sums today is uBank at 1.8% for 6 months.

Michelle’s retirement nest egg would today only generate at best ($600,000 x 1.8%) $10,800 per year or $207 per week. That is a third of what it generated in 2011 and less than half the $466 weekly pension. Michelle, like many must now scrape by with a part pension and a fraction of the money she received just 8 years ago.

I speak with lots of people like Michelle that have followed this same retirement plan. This age old, seemingly low risk, term deposit strategy that has worked from the 1960s to just a few years ago. What has happened over the past 5 years was not anticipated and as a result many are now enduring a brutally hard retirement lifestyle.

The graphic below details the fall in term deposit rates over the past 35 years and really brings home the problem that many older Australian’s are facing.

People in their 70’s and 80’s assumed their investment nest egg of cash in the bank would generate them enough money to live on. In 1985 they would have been getting 12% on their money and in 1995 they would have been earning a tidy 10%. Fast forward to today and retirees are now only getting around 1.5 – 2.0% on their money, that’s not enough to live on. For Valma, Kathy and Rod they were faced with spending their nest egg or seeking alternative ways to generate a return, this is what led them to the Engines of Wealth team to investigate purchasing a commercial retail shop.

I interviewed Kathy after her purchase as I was intrigued to understand the drivers that led a 72-year-old retiree to buy her first retail shop. Her reasons were twofold, firstly, she realised she could not live on the interest her money was generating in the bank and that meant she needed to spend some of her nest egg each year to survive. Kathy’s decision to invest her money in a retail shop at secure 6.5% cash flow return, meant she would now be generating sufficient income for her to live on without eating into her nest egg.

The second driver for Kathy was protecting her children’s inheritance, Kathy had benefited from an inheritance from her parents and hence it was extremely important to her to also leave something for her children. It comforted her to know she would be able to leave them the legacy of an income generating shop, that was increasing in value each year as the rent increased.

There is a growing number of retirees suffering from what is happening with interest rates and the solution needs to be something other than traditional, low risk investments like bonds and term deposits. This older generation is particularly sceptical of turning to the stock market, as they experienced the GFC and know how volatile local and global financial markets are at the moment.

I am glad that by reading my book, Engines of Wealth and then contacting me, I was able to help improve their livelihood and ultimately empower them with the knowledge and confidence to change their investment strategy. Kathy and Valma both said they are delighted to have secured a safe, steady income stream from their commercial shop and take comfort in knowing their money is protected in bricks and mortar, both have dramatically reduced their stress levels, they are now no longer worried about their future prosperity.

I would like to finish with a photo of a very proud 85-year-old Valma, in front of her shop. Congratulations Valma, an outstanding achievement.

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How Many Shops do I Need to Retire?

When I first spoke with Phillip to understand his commercial property investment secrets, I quickly realised this was an investment strategy and asset class suited to my personal financial strategy. I undertook a one-on-one consulting session with Phillip for over 3 hours and was inspired by the possibility of creating a long-term income stream. I immediately began scouring the websites for attractive retail shops. I now own 12 retail shops that are fully tenanted and serve as the foundation for my current and future income plans.

With this background, let me step back in time to the very first question I asked when I decided commercial properties were going to be my future income engine:

“How many shops will I need to ensure I have enough income to last until I die?” 

Whether you are a savvy 22 year-old with a small deposit or 50 years old looking to leverage assets you’ve accumulated over 30 years of work, setting a future plan to have sufficient cash for comfortable retirement living is important. Many people today just survive on their retirement income and pension, they don’t have enough money to really live. I was in my late 40s when I spoke with Phil. At that time, I had just paid off my home, I had stopped working for a large corporation and went into business for myself.

For me it was a great time to think about life after work, or at least a simpler life working part time, and the question I needed to understand was how much money do I spend in an average year/month. I captured my expenditure in the table below as a starting point. Of course, this amount will vary from one individual to another depending on aspirations, but it is useful as a reference point for my target shop rent. The two assumptions I have made is that my house was paid off and the kids are no longer at school or university.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

My post tax monthly expenditure was $9,570 per month or just under $115,000 a year. Therefore, as a starting point my wife and I need to split almost $150,00 pre-tax income to live our existing lifestyle.

In setting a long-term income target for my retirement, I reflected that today’s costs will be indexed to inflation and that cost increase will be covered by the income generated from the shop rents that are also indexed to inflation by annual rent increases. So these net out making my calculation on the money I’d require in the future easier. I decided that the $150,000 I need today is a comfortable annual income target to adequately fuel my retirement. Others may require more or less, but this amount sets my income bar to answer the question of how many shops I need to retire.

At present, the income generated from my 12 retail shops is combined with income generated from my business to sustain my family. Over the next 10 years, I plan to pay down my investment loans and acquire more retail shops until the annual income from the shops alone reaches my retirement target of $150,000 per year. Defining when I have enough shops in my portfolio to fuel my retirement, comes down to a simple formula:

Cumulative Shop Net Rent – Bank Interest for the Shop Loans ≥ $150,000 per year

At present, my portfolio of 12 shops is secured by my home as security. It is important to continue leveraging the equity from my house and these existing shops to procure more shops. At present, my shops generate $181,000 in net rent. The loans on the shops total $2.35m resulting in an annual interest bill of $108,000 per year. Plugging these figures into the ‘retirement’ equation shows:

$181,000 – $108,000 = $73,000

By this calculation I am almost halfway ($73,000) towards my $150,000 target from the 12 shops I have today.

To achieve my retirement income target I will need shops generating almost $360,000 in net rent annually (double the $181,000 I have today). Now to collect this amount of net rent there are positive and negative forces that will speed up my shop income journey or slow it down, some of these are:

Positive Forces

  • Annual rent increases built into the lease will keep my cash flows indexed better than inflation
  • Market rent reviews on lease expiry may lift rental returns faster than CPI
  • Income from my job and the shops will continue to pay my loans down reducing my interest bill and increasing my annual cash flows
  • The reserve bank may lower interest rates over the next 10 years
  • Population growth in the selected areas I choose to invest may drive rents up with increased demand
  • By structuring my investments optimally to manage the tax burden, placing some shops in my wife’s name
  • The government may lower personal tax rates.

Negative Forces

  • A tenant vacancy over the period will compromise the income in that year
  • The Reserve Bank may increase interest rates over the next 10 years
  • A softening economy may place downward pressure on rents
  • The government may abolish deductions available to commercial property owners, for example, travel expenses to visit the commercial property, negative gearing from temporary vacancy
  • The government may increase my tax rate.

All of these ups and downs are possible, but I am confident that once I achieve my target of $150,000 in annual shop income, it is sufficient and indexed with inflation to grow in-line with the cost of living. In essence, I believe the annual increases and market reviews built into the shops’ leases are future-proofing the net rent and my retirement income. Furthermore, I am confident that in following Phil’s directions, as outlined in Engines of Wealth, I have selected properties that are secure and strong in tenancy to optimise these ups and downs.

Armed with this insight the question “How Many Shops do I Need to Retire?” should be redefined to “How many shops do I need to generate my target retirement income of $150,000?”. Presuming I need to collect 24 shops (double my 12 today) to retire is a false target, this implies all shops are the same, some shops are big and some shops are small, some generate $40,000 in gross rent and others can generate over $400,000. Keeping it simple, I borrowed $2.35m to secure half my target income from shops that on average deliver a 7.5% return on my investment. Assuming I secure future shops at this return and continue to borrow 100% of the property amount, I will need a property portfolio supporting borrowings of $4.7m, that’s roughly double the debt I have today.

Among all of these numbers, the key figure to focus on is the retirement income target, for this will dictate the number of shops needed.  As I am halfway into my commercial property investment journey, I agree with something Phillip says in the book, “there is always room for one more”. Happy hunting.

Written by Stephen Hains

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Tenants That Default!

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Written by Stephen Hains

In the article “Tenants that Don’t Pay”, Phillip outlined steps and approaches to manage tenants that pay late.

The steps to encourage tenants to remedy their rental arrears includes a legal letter of demand and contains a warning that they have 14 days to remedy their arrears or you will lock the doors. In the very rare cases when a tenant defaults on their lease it is important to know what the landlord can do to minimise your exposure.

Recently one of my café owners indicated they were experiencing financial hardship and wanted to move from monthly billing to weekly. The tenant had another shop that he also operated nearby that was doing well, and that shop was propping up the struggling cafe. Based on the overall cashflow from both café’s I agreed to the weekly invoicing for a short period – until the tenant’s shop improved its turnover.

Weeks turned into months and although the tenant seemed to be doing everything right their fortunes did not change and they slipped into rental default. The tenant started missing rental payments and ignored my requests to source a personal loan from the bank, after the tenant reached 4 weeks in arrears I had no choice but to issue a letter of demand giving them 14 days notice to remedy their arrears or be locked out. The tenant could not remedy their arrears and provided me notice that they would be closing the business.

The tenant had pulled the pin 18 months into a 5 year lease, not only was I out of pocket 6 weeks rent, I now faced the challenge of finding a new tenant. I would need to meet the cost of advertising, paying agent commission fees and the typical request from an incoming tenant for a rent free fit-out period, or a fit-out contribution.

The exposure is magnified by a period of no rent while the shop was vacant. But wait, don’t forget the tenant’s bond is available to mitigate the loss. When I purchased this shop, I inherited the tenant, I knew he was a highly regarded chef that was running two cafes in neighbouring suburbs. Having two shops and the lease in a company name (Pty Ltd) is usually a warning sign, but the lease had a significant 4½ month bond, held in the form of a bank guarantee. Having the lease in a company name means if they default the landlord has no access to the tenant’s personal assets, i.e. their home.   The original landlord protected themselves against this risk by requesting a large bond, hence this security transferred to me as the new owner.

When the shop’s doors were locked, the tenant had cleared out some of their items and called in an administrator. The tenant left behind tables, chairs, fridges, beer kegs, iPad, hundreds of dinner plates and cutlery and a $200,000 fitout that was just two years old. These were all the assets this now bankrupt business had, so the tenant abandoned them for the liquidator. The fit-out included cool rooms, stainless steel benches and cooking equipment, plus a $120,000 rangehood. All these items were custom built for the shop and financed on their own lease with the supplier.

At first, I thought “Thank goodness I have a large bond and the new kitchen fit-out should enable me to attract a tenant quickly”. The typical avenue to pursue the tenant for damages, lost rent and advertising costs quickly closed when I was informed by the administrator that the tenant owed $260,000 to the ATO and the bank. The banks and other secured creditors holding first mortgages will strip any remaining assets well before my claim gets addressed, there would be nothing left.

The sage advice from my lawyer when I locked the doors was “don’t hold your breath for anything other than the bond you’re already holding”. I quickly executed the bank guarantee bond which meant it was no longer an asset of the failed business, it is rent in advance. Therefore removing this as a potential asset for the hungry secured creditors.

The next concern was all the equipment left in the shop, although this made it look occupied for advertising and the future restaurant tenant, it meant I had to dispose of it if the new tenant did not want it. Also, don’t forget the large items (cool rooms, rangehood) were on a lease and the liquidator was requesting a payout of the lease about a month after the default. Note, as the landlord you have the high ground with these fixed assets, they are not in your name, they are large assets and liquidators do not want to remove them as they would have a greatly reduced second-hand value. Ideally they attempt to negotiate a buy-out figure with the new incoming tenant to take on these assets. The advantage for the new tenant is that often the assets can be secured well below their market value, as liquidators typically want a rapid close to proceedings so they can write these distressed assets off their books and close the matter.

With regards to the liquidator, time is on the landlord’s side, until a new tenant is secured and has indicated which assets they wish to keep, the liquidator can’t do anything. In preparation for my new tenant I had negotiated all these leased assets for a price of $14,000, down from its $200,000 position two years earlier. When the tenant finally indicated what assets they wanted, it was only half the items on the liquidators list, I then managed to negotiate these items for just $6,000. However, as expected, the liquidator did not want to incur the cost of removing the remaining assets and simply chose to write them off. I included all this equipment as part of the new lease, instead of a typical 6 month rent-free period for a 5 year lease, the new tenant agreed to 3 months with all the equipment included.

By the time I had a new tenant signed up it was 5 months after originally locking the doors, I then incurred a 3-month rent-free period for the tenants fit-out. The total period of lost rent was 9½ months, the bond accounted for 4 1/2 months of this, but there was also advertising and agents commission for the new tenant which equated to two month’s rent. All up, I was 7 months of gross rent in arrears.

A failed tenant is an unwanted thing to endure, but it is good to know there can be light at the end of a dark tunnel. For me, I secured a new burger restaurant chain that has added value to my building, I now have a new tenant that has invested heavily in his fit-out and signage giving me the confidence that he will be there for many years to come.

Some of the lessons learned from this experience:

  • Avoid tenants that split their time between two or more shops, this usually means their focus is diluted and long hours required to manage two shops tends to be unsustainable.
  • Beware of tenants operating the lease as a Pty Ltd. As a minimum you should request a personal guarantee and where one won’t be provided then a larger bond or bank guarantee should be sort.
  • There’s an old expression, “Cash is King” and holding a large cash bond or bank guarantee was better than a personal guarantee.
  • Do not allow tenants to get beyond 1 month in arrears before you issue a letter of demand to remedy within 14 days.
  • Do not count on anything from a defaulter other than the bond. Any more than this is a bonus, the landlord is an unsecured creditor and often the last in the line of creditors to be paid.
  • If you have a bank guarantee, go to the bank immediately after the tenant defaults to cash it in. You don’t want other creditors making a claim on it.
  • The bond never covers the vacancy time, advertising and rent-free period, so start advertising for a new tenant as soon as possible
  • Consider a rainy day account to cover at least 4 months of the mortgage and outgoing payments, just in case.
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