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

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

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