Should I Consolidate or Diversify my Loans?

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When I speak with new clients starting their investment journey in commercial property, the first thing I need to understand is how financially ready they are to invest.

Understanding their available equity and how best to leverage it with the banks is critical. One practice that I see all too often is the diversification of lending across multiple institutions. Many investors believe there is safety in using different banks across their investment portfolio. This article answers the question: Does an investor benefit when they Diversify their loans or Should they Consolidate their loans with a single bank?

It is important to assess the pros and cons of using multiple lenders when building a portfolio of investment properties, as shown below:

Diversify (Multiple Lenders)Consolidate
  • You can create competition for your business across multiple banks, thereby attaining the lowest possible interest rate
  • You can access all your equity through the one bank, this gives you much greater leverage and borrowing capacity
  • You’re borrowing with the one institution is more significant, hence you are able to negotiate lower rates and better terms for all your loans versus a single loan
  • You will be able to play one bank off against another giving your business to the most competitive lender
  • Payments from multiple tenants can be easily consolidated into the one account and directed to your domicile loan
  • You are not at the mercy of one bank and can readily change to another bank if rates or fees are not in your favour
  • You simplify administration and only need to deal with one bank, one set of accounts, one password, one login, one bank manager to call
  • You are not tied to one bank if they change their lending policies on LVR and risk

 

The four Diversify points above all sound like reasonable statements, however it would be extremely rare for a major lending institution to change their national lending policies to win your business especially if the loan being considered is less than $1,000,000. Therefore, whilst these motherhood thoughts of safety are comforting, I doubt in the heat of negotiations they would result in the outcome you anticipate.

In the book Engines of Wealth, we outline the top priority to build wealth is Leverage! In order to grow your investment portfolio, you need access to all of your equity, without this your ability to borrow will be restricted.

As an example, let’s take a look at an investor with a portfolio of 4 retail properties each with a purchase price of $400,000 and each with different residual amounts on the loans with four different banks. Then we will compare their borrowing capacity versus consolidating these four loans.

 

Example: 4 investment properties with CBA, ANZ Bank, Westpac and NAB

consolidate-or-diversify-loans

 

This investor has plenty of equity at their disposal. Each of the 4 properties are valued at $400,000 and the banks lend based on a typical 70/30 LVR (Loan to Value Ratio) position, then they would need to invest ($400,000 x 30%) = $120,000 of equity in each property. As shown in the above diagram, this investor has paid down the loans over time and currently has a total of $520,000 of available equity. The problem with this Diversified investment strategy is trapped equity! In total $280,000 of equity is stuck in NAB, $180,000 is trapped in Westpac, $80,000 is locked up with ANZ Bank and finally CBA may be charging this investor mortgage insurance because this LVR position is only 75/25, which is less than their standard 70/30 lending policy.

By diversifying these loans this investor is unable to cross collateralise their equity across the banks. They can only access the $520,000 in available equity to buy another property if they Consolidate the loans with one bank.

In addition to this, under the diversified model each bank would mandate rental payments be directed into the individual loans to meet their banks mortgage repayments while the more sensible approach for the investor would be to direct payments off a domicile loan that isn’t tax deductable.

Applying this example to a Consolidation strategy with all 4 loans with one bank, then this bank will hold security over all 4 shops. The total equity position is:

 

 

 

 

This is a very healthy LVR position. At 70% LVR the bank would lend $1,120,00 for this portfolio, hence with only $600,000 in remaining debt it releases $520,000 in spare equity to procure an additional property.

Based on the same 70/30 LVR, this investor would be able to buy a 5th property valued at:

 

 

 

 

Using a Diversified strategy to buy a 5th property, this investor could at best leverage the $280,000 equity available with NAB to buy a property valued at:

 

 

 

 

Diversifying your loans traps equity within individual banks and makes it very hard to leverage all of your available equity.

The team at Engines of Wealth would be happy to assess your situation and provide our experience on unlocking your full borrowing potential.

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

stephen@enginesofwealth.com

phillip@enginesofwealth.com

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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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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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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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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.

 

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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.

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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.
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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”.

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