6 Critical Tips for Commercial Property Investment

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Authors Stephen Hains, Phillip King – Engines of Wealth #enginesofwealth

An Engines of Wealth client recently asked me “What are some tricks selling agents play and the common pitfalls when buying a commercial property?”. 

 

This is a very good question for anyone building their commercial property portfolio.  Below is my response, 6 critical tips that are part of my routine when I analyse a property.  As you can see, they have a big impact on the value of a retail property.

 

1. GST Trap – some agents are listing a property for sale with GST included in the net rent.  I experienced this twice last year and it made my blood boil as unscrupulous agents know that inflating net rent increases the sale price.  This practice deceitfully inflates the property value by 10%!

In addition, there are other GST traps to consider as a landlord to ensure your purchase is GST exempt. The Government offers an exemption if the transaction is deemed to be “The supply of a going concern”. So it’s important to understand if you need to be registered for GST and what GST status the current owner is, as this will determine if you need to charge GST on the rent.  We wrote the following article to provide some background on the GST challenge.

https://enginesofwealth.com/to-be-or-not-to-be-gst-registered/

2. Gross versus Net Leases – understanding who pays for the outgoings is the most important factor in determining the value of a shop.  The higher the net rent, the more you will pay.  It is imperative a buyer knows from the executed lease what the tenant has agreed to pay.

The lease will state that outgoings are one of the following:

    • 100% paid by the tenant
    • A specified percentage for the centre based on the shop’s sqm footprint
    • A list outlining exempt outgoings like Sinking Fund and air conditioner maintenance
    • Nil payment – no payment of outgoings means it is a gross lease.

The critical point is to build an accurate view of the true net rent. The value of the property is based on this net rent so it needs to be right.

 

3. Charging Land Tax is Illegal, but Sinking Fund is allowed – there is a lot of confusion on whether a retail shop should pay Land Tax and the Body Corporate Sinking Fund contribution.  Many leases I see for cafe’s, hairdressers and restaurants indicate that like other outgoings, both of these are the tenant’s responsibility.

In many cases, the tenant does pay these without question. What many tenants do not know is that regardless of what is in the lease, the Retail Leases Act mandates that Land Tax cannot be passed onto a retail tenant. However, this tax can be issued to an office or medical tenant as these do not come under the protection of the Retail Leases Act.

 

For the Sinking Fund, some lawyers argue this is the landlord’s expense, however, we rely on sections 37(2) and 40 of the Retail Leases Act where outgoings includes maintenance amounts that are part of the tenant’s outgoings under the lease. Our position is that a body corporate sinking fund is a deposit which exists to pay for repairs and maintenance of a building.

If the landlord charges retail tenants land tax and is reported to the Office of Fair Trading, legal proceedings and penalties could be imposed. As a buyer, during your due diligence of a retail shop purchase, you should be instructing the agent to remove Land Tax from the recovered outgoings.  Plus if the owner is not charging Sinking fund today then it too should be removed from the recovered outgoings. As a result, you reduce the net rent and hence lower the valuation of the property.

The tip here is that non-retail shops, including doctors, dental surgeries, offices for accountants, lawyers, etc. are eligible to pay both Land Tax and Sinking Fund contributions under their lease.   

4. Alarming Omissions – in our book we spend a lot of time discussing the outgoings that must be included to get the true net rent figure.  We wrote the attached article on what to look for when assessing outgoings on a property: https://enginesofwealth.com/alarming-deceptions/

The tip here is to ensure the real estate agent has fully disclosed all the outgoings. More often than not agents will disclose the Council Rates, Water Rates, Insurance and that is it!  They expect you to believe there are no other expenses. You need to ask them about the cleaning, gardening, fire inspections, annual audit and management costs to get a true picture of the net rent.

5. Beware of Broker Margins – one of the very first steps for our Engines of Wealth clients is to understand their financial position in order to establish their borrowing capacity.  Clients often use more than one bank across the personal home loans and investment loans to get the most competitive rates.  We recommend our clients speak with a broker, given the interest rate and loan quality is paramount for commercial investments.  What many don’t realise is that not all brokers are the same and this can have an impact on the interest rate of the loan!

Buyers of retail property predominantly want three things:

  • To maximise their borrowing capacity
  • The highest possible LVR (loan value ratio), and
  • the lowest interest rate.

When selecting a broker it is important to assess the company’s size and which financial institutions they are certified to work with.  The brokers monthly turnover is important as some larger banks will only deal with brokers that write $5m in loans per month.  Smaller brokers often use an aggregator to deal with the major lenders, however this adds another layer of commission to the loan.

Look for a broker that offers an extensive list of certified lenders, the best loan may come from the bank that already holds your residential home loan. If the broker is not certified to deal with your existing bank, then they may not able to offer you the simplest lending options.

The tip here is picking the right broker that works with your existing lender to ensure you follow the simplest path to securing your funding. It’s important the broker you select also deals with multiple lenders as they will have a knowledge base of what deals are in market and what banks are offering in terms of LVR’s and interest rates.

6. Dispelling the Insurance Dilemma – as a new owner many are unsure of what insurance is needed.  There are three questions to consider: What insurance is the tenant required to have?  What does the landlord need?  When should the landlord secure their insurance?

For the tenant’s responsibility, the lease should indicate that they require public liability insurance (usually $10 million coverage or more) and glass insurance for the windows.  For the landlord, if you are buying a shop in a body corporate strata scheme, then the Body Corporate fees include building insurance and public liability insurance for the common areas of the building.  In addition to the protection the Body Corporate policy provides you should also have your own public liability insurance protecting the inside of your shop from the time of Contract signature.  This gives protection if an injured party chooses to sue the landlord not the tenant.

To avoid public liability duplication, the landlord could ask the tenant to name them on their policy as an interested party.  However, this does not protect the landlord if the tenant does not keep their policy current.  For more detail on insurance and this issue around Public Liability please look at the article below:

https://enginesofwealth.com/insurance-do-i-need-it/

I trust these critical tips assist in making better property choices.

Please contact the Engines of Wealth team if you have any questions:

stephen@enginesofwealth.com

phillip@enginesofwealth.com

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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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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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Air Conditioners

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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

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Dangers of Short Lease Terms

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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

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The Value of Depreciation

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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

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Guarantors

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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

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PROPERTY SEARCHES DURING DUE DILIGENCE

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PROPERTY SEARCHES DURING DUE DILIGENCE

I can safely say that the most important task your solicitor will conduct during the shop purchase process is due diligence, that is to ensure the asset you are buying has no encumbrances, will not be impacted by caveats, zoning changes or future government acquisition. Thorough due diligence is achieved by performing a series of statutory and non-statutory searches on the property you are buying. Each search has a specific use from ensuring the person selling you the property actually owns it, to checking future road widening will not encroach on your property causing it to be acquired by the government. Read more

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Tenants That Don’t Pay

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It would be a nice world if everyone did the right thing at the right time, for retail tenants that means paying their rent on the 1st of every month, like clockwork. Unfortunately we do not live in such a perfect world and you may come across a tenant that has poor cash flow and believes it’s OK to use you as his bank and is regularly late in paying the rent. Read more

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Real Estate Agent

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In Engines of Wealth I discuss at length how to interact with real estate agents from a buyer’s perspective, but when considering them as a tenant and agencies are one of my preferred tenants, there is a twist. When considering the viability of a real estate agent in your shop first you need to ascertain if they are among the 90% that sell residential properties only. Remember the catch-cry “Location, Location, Location”, all areas are not equal and if your shop’s neighbourhood is not providing attractive prices or has too much competition then a real estate agency may struggle. Read more

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