How to go around this situation

[sanjayag]

For a friend of mine:

PPoR value 180K
Loan balance on PPoR 100K (CBA)
Cash Available 50K

Running a takeaway restaurant on a leased property for the last 3 yrs. Wants to buy a shop for 260K (offer accepted) and start a proper restaurant (dine-in).
Having sufficient cash (other than 50K indicated above) for the renovation to convert the property to a proper dine-in restaurant.

Question: How to arrange finance for best tax benefits and max cash flow?

 

[Aaron_C]

I take it if he bought the new property he would close down the existing restaurant? Or will he keep both?

In either case, commercial property's maximum leverage is ~70% so he'd need more than 50k even if he could service the debt. This may have to come from either a cross collateralisation or a refinance of his PPOR to tap into the equity.

 

[sanjayag]

Thanks for the quick reply.
He is ready for cross-col with the PPoR.
The bank (CBA) is ready to lend at 8.35%, but seems too high.
My original questions was more towards the structure for max tax benefit. For eg.
He deposits his 50K in PPoR loan releasing more equity. And then bank lends him 105% (tax benefits thru' business).

 

[Aaron_C]

8.35% for a standard commercial property loan where the borrower is OK at best is pretty standard across all banks. You might get it a bit cheaper here and there, but you can't compare it with residential rates because it's so different. If you want a rate in the mid 7s, your comm LVR has to be pretty low (~50%) and you need to have very, very strong servicing.

But in answer to your question, yes it would be best to put the 50k into his PPOR loan, then refinance to extract the equity out for use in his business/commercial property. Then he will have the maximum amount of deductible debt. I, however, would advise him to try and avoid cross collateralisation if possible. In business - the last thing you want is the bank to have full control if the proverbial hits the fan.

 

[sanjayag]

I think I read somewhere quite a while ago: Even if you don't X-col, the bank has right on your other properties against default on one property, providing the other property is also with the same bank. Is that correct?

So....the interest rate of 8.35% (3 yrs fixed) is OK? even after the rate cuts recently?

 

[Aaron_C]

I think I read somewhere quite a while ago: Even if you don't X-col, the bank has right on your other properties against default on one property, providing the other property is also with the same bank. Is that correct?

So....the interest rate of 8.35% (3 yrs fixed) is OK? even after the rate cuts recently?

Yes that sounds right. That's not what I was talking about though. X-Coll is most annoying when you haven't even defaulted...if you choose to do a progressive sell-down of your properties, the bank will have full control of where the money goes. Most times, all the proceeds will be used to pay off the loan and you get nothing from the sale in your pocket until you sell everything. Not a good situation is it?

The interest rate sounds normal to me. Like I said earlier, you might get it lower, but it really depends on how strong your friend's financials are.

 

[Rolf Latham]

as an aside, I assume ur friend has lots of operating cash ?

ta
rolf

 

[sanjayag]

He is already in the business which is going good (in small scale).
The bank before approving the loan, asked his accountant to provide the cash flow statement and last two yrs tax return. He has got appliances etc already in use and of course the cashflow for running the day to day operations.
He and his wife are partners and both work in the business full time. Apart from that they have another person part time working for them. They are trying to sponsor another chef from India on work visa as the business is demanding.

 

[Peter_Tersteeg]

The cost of the loan and the ability to borrow money is very important, but I'd suggest that the ownership structure of the business and the property is probably going to have a bigger impact on the long term prospects.

What your friend proabably really needs is to do some business planning with his accountant.

 

[RightValue]

Why does he have to buy the building to convert it to a sit down restaurant?

He can do this in the leased premises.

The margins sound way too tight as buying the building will consume all his cash and he will be putting all his eggs, income and assets in one basket.

The property investment decision should be different from the business decision.

If his rent is less than $21,000 (8.35% ON $260K) then he is paying way more in interest/opportunity cost to own rather than rent.

You make your money by the business turnover and by selling the good will and this is scalable whereas the income from the property generally is not.

If the business goes down or does not work they will be out of work and out of home with no assets.

Quite frankly I think he is probably better off renting than buying, most business should get a far higher return on capital than the yield on the property.

BTW, most Restaurants do not make money, whereas takeaways often do.

just some thoughts.

RightValue

 

[Bird Dog]

^^^^what^^^^he^^^^said^^^^

RV raises some valid points.

The topic of "why do business owners prefer to rent rather than own their premises" has been discussed many times in this area of the forum and the overall sentiment, is that most would rather invest the capital back into the business to get a better (short to med term) return.

Yes, there are valid reasons for a business owner to purchase their premises however this usually occurs for one of a few reasons...

• They need a very specific building built to spec and no landlord is willing to go down this path with them..
• The business has established itself firmly within the location and is certain it works and is right for them. They also must be certain that they will not outgrow the location to quickly.
• They have oodles of cash and can't bear the thought of paying rent to a landlord.

By the sounds of it, your friend fits into none of these categories so I would be seriously considering RV's advice and going down the path of leasing first (even it means a significant fit-out) and validating the business viability first.

Perhaps another option is he negotiates an advanced purchase "option" in 2 years with the current owner.
He could negotiate a clause that gives him first option to purchase the property for "$X" (x can easily be determined via rental increases and lease options etc) but it doesn't necessarily lock him in should he change his mind.

At the very least, he'll then be able to invest the spare capital back into the business right at the beginning (when he needs it most) and he'll still have the option of purchasing once he's on his feet.
He'll also be a better position to negotiate rates with the bank once he has two solid years of trading as a restaurant under his belt.

And if it all goes t*t's up, he's only responsible for the lease rather than loosing the lot..

Cheers

B.D

 

[sanjayag]

Thanks for the suggestions. To make the discussion more relevant:

At the moment, he is leasing a place for his takeaway outlet. It is not suitable to be converted into sit-in restaurant. However, he has got some tables where some people like to eat. There is not a proper toilet and proper parking. The lease is finished so going on month-to-month basis atm.

It is a small town, not many properties at the correct loaction. He is interested in this property because:
1. It's location
2. Good building size at the street corner
3. Separate space besides the building, suitable for 8-10 car parks.
4. A nice piece of land behind the main building (part of this property), suitable for building a care-taker residence (council agreed verbally).
5. The lease cost for this property is more than what he will pay for the interest.
6. The owner is not ready for the 'option'.

He is very optimistic he will have much better turnover with the new property. The main expenses are in the kitchen ( making it bigger, a cool-room, a big dish-washer, plumbing, grease/oil trap etc). Few thousands for the furniture too..

 

[lizzie]

BTW, most Restaurants do not make money, whereas takeaways often do.

This is a hugely valid point - which is one reason why Pizza Hutt doesn't do the restaurant bit anymore.

Another factor is that, even tho the property is in the right location this year but - given any number of events - in 5 years time the location could be completely wrong, but he is stuck with his now poor location because of buying.

I am not commercial savvy - but have seen this occur time and again where a hot spot this decade is next decades' dive.

Newcastle is a key point. Those who bought in the bustling inner city prior to 1989 struggled desparately post 1989 as the CBD died as various key elements of the "city centre" moved to Darby St, Hamilton, The Junction, Charlestown and Kotara. A major was when the main hospital moved out of town to Lambton.

 

[sanjayag]

Lizzie,
If I remember correctly, I read in one of your post that you stayed in Whyalla for some time. His current location is the down-town street which is dying and many shops are empty. So he wants to move to better part like Playford avenue or Essington Lewis Avenue, where more and more businesses coming up.

 

[Bird Dog]

5. The lease cost for this property is more than what he will pay for the interest.

You'll find this is pretty common with commercial property Sanjayag! Even more so with a regional town.

Have your friend educated himself on cap rates and how they relate to regional commercial properties and he may not be so keen to "buy".
The truth is regional carries a higher risk as things change (as you have already mentioned about the main street) so most landlords want a quicker return on their investment as they usually have to carry longer vacancies which in turn hikes up the lease costs.
Why would you want to lock your (brand new) business into restricted cash flow AND a site that may or may not be the next big thing.

It sounds however like your friend already has his mind set on what he plans to do and is only interested in how to make the numbers work.

At the very least, he should be speaking to a professional accountant about how to structure the finance..

Good luck

B.D

 

[lizzie]

Lizzie,
If I remember correctly, I read in one of your post that you stayed in Whyalla for some time. His current location is the down-town street which is dying and many shops are empty. So he wants to move to better part like Playford avenue or Essington Lewis Avenue, where more and more businesses coming up.

With the Whyalla steelworks expected to downsize it's workforce by significantly (if not close altogether) in the near future, I wouldn't be buying anything in Whyalla at all. There are already several hundreds redundancies in play at the moment.

I know what you mean with downtown - problem with Whyalla is that there really is no city centre, or location centre for anything, except for around the new-ish shopping centre.

I know there is the mine outside town, but being an hours drive away I think if the mill closes, and hence Whyalla starts to die again, then those that work in the mine will probably relocate to some of the smaller towns that are closer.

Port Augusta and Port Lincoln are much better places to invest and grow a business - imo.

 

[lizzie]

Spoke to hubby last night - who is more in the know than I. He laughed at the thought of buying in Whyalla atm.

He said there was another mine coming online in the near future between current mine and Whyalla, and that shipping would still be out of Whyalla, but if the steelworks closes then the loss of jobs (and flow down jobs in service and retail) will in no way be made up by mining.

 

[Bird Dog]

With the Whyalla steelworks expected to downsize it's workforce by significantly (if not close altogether) in the near future, I wouldn't be buying anything in Whyalla at all. There are already several hundreds redundancies in play at the moment.

Ahh, the joy's of regional..
A major employer closes it's doors and the whole town in affected...

People ask why I invest in something risky like commercial but think nothing of pouring their cash into mall town of less than 25,000 people who's single biggest employer (18%) is metal manufacturing and they are shutting up shop..

And you your friend wants to buy there.... really....

 

[lizzie]

And it's not just the 18% that work for the steelworks directly that would be affected.

For every direct employee, I would image there are 1-3 dependants each (wife and kids), and another 2-3 working to service each of their needs - supermarket, takeaway, home services, schooling, hospital, general retail, car servicing/sales, banks, petrol/carwash, vet/pet care etc etc ...

 

[sanjayag]

I joined OneSteel in Apr 2007, and am hearing about uncertainity of its existence even before I came here. At the moment, I think it is not closing down in near future. Company just put $65m to repair the furnace and heaps of other money in other projects including a desalination plant. They are putting lot of money in the existing port (inside the steel mill). There is no more red dust for which the town was notorious as company has changed their technology. At the moment, they are focussing on mining expansion but still want to run the steel plant. A big construction about Quest aparments is in full swing. Extension of shopping center is approved and construction phase 1 started. New big public library is about to open. K-Mart is coming. Most probably Bunnings too.