Jumping in the deep end

[KSTA]

After months of looking at residential PI my husband and I purchased an industrial block of land as we felt given his background in building design we knew more about this area and we could use his skills to design and lodge applications to coucil. The catch - instead of a $400K outlay we have spent $200K and are looking at another $5 - 600K to build. We can only build if we get a pre-construction tenant.

We have an interested national tenant, but they are after 10 +10 year lease - 12 weeks rent free (sounds like a lot) and suggesting a lease rate that would bring us a 10% return. The agent is pushing us for a counter offer and to be honest I feel like we are plucking figures from thin air. This forum has been very informative, but I feel we need further advice - who do you trust?

Concerns: 12 weeks rent free sounds excessive - it is a new estate, access hasn't been finished, but a major national tenant (much bigger than our fish) has purchased 2 blocks down. I thought rent free deals were only for desperate developers trying to get the first cab off the rank?

When doing a pre-construction lease do you demand a deposit or charge a bond - elsewhere on the forum people have suggested 3 - 12 months rent up front. Is there a formula for working this out? Doesn't a deposit or bond contradict a rent free period?

10% return - what does this mean? We have been told it is the cost of the project divided by the expected rent? Is this true - if so is this considered reasonable for an industrial IP.

Rent reviews? How do you determine a schedule for increasing rent - is it just CPI? When do you factor in a market review ? Is 10 years + 10 good or too limiting given the stage the development is at?

We have purchased the land as a partnership - abn + gst registered, but the bank will most likely want a fair amount of the equity in our home - implications of this?? mixing business and personal assests? Is this possible.

Sorry, lots and lots of questions - I am well out of my depth and treading water, keen for our first dip into the IP pool not to be out last. I hope someone out there can help answer some of these questions.

Cheers,
KSTA

 

[JoannaK]

the sorts of questions posed in your post are the type of questions one should seek answers to before they even consider buying a property, not after they've already bought it...especially for their first time!

you mentioned "the agent", is that an agent employed by you and working for you or is it the agent acting as the tenant's representative?

if you haven't got yourself an agent then I would strongly suggest that you get yourself one, preferrably one with a considerable amount of experience in these sorts of deals.

as for 12 weeks rent free? well, I can't comment, but rent free incentives are common in commercial/industrial transactions.

I'm sorry to sound harsh, but if you feel like you're plucking figures from thin air then you probably haven't done your research as thoroughly as one should do when entering a new market for the first time.

take a good look at your building plans, and discuss these plans with a number of commercial agents; they will be able to tell you about similar property yields in the area....that will help to eliminate the "plucking figures from the air" feeling you're currently having.

sorry, my response falls considerably short of answering your questions, but if you've already bought the property you should know the answers already.

 

[KSTA]

Cheers

Point taken JoannaK - I have read a number of your posts and I appreciate your reply, even if it seems a little harsh.

To clarify a few points. The agent is a very experienced industrial/commerical real estate agent. Most of our figures regarding estimations for rent have come from him or our mortgage broker and are based on what is happening in the area. Both of these people are saying that the numbers stack up and to go for it. I guess trust is a problem of mine and I like to source information from a variety of places.

We know the price we paid for the land is excellent and have since seen prices increase $20 - 40/ sq m in the same estate.

My husband's job has seen him involved in the the planning approvals etc of a few projects in the same area - so we have a rough estimate of costs, council protocols. We have ball park quotes for construction and my husband has a professional relationship with a number of people in the construction industry, but when it comes to leases our knowledge is lacking.

As I said in my first post we have been told we could get a 10% return and that this is based on the expected rental return divided by the price of the project - is this the correct definition ? I have read about people referring to x% net yield - is this the same thing? and if so is 10% an acceptable return for this sort of project ?

I guess everyone starts somewhere and learns along the way we know we can't lose on the price of the land, but don't want to sell ourselves short given the possibility of prices in the estate increasing. My intention for joining the forum was the hope that those more experienced out there could help enlighten me - instead of me just relying on my husband's say so.

 

[Belu]

Hi KSTA,

basically the return is the rent per annum divided by the cost of the property. GROSS return is when no costs have been taken into account whilst NET return is when all costs except depreciation, interest and mortgage payments have been taken into account.

It looks like a good return, just see if the free rent is included in the 10% return and what kind of bond to get. Plus you will have $12,000 + in depreciation a year which is another $3-4k in tax savings which is always nice.

With rent reviews, get it adjusted at least by say 3% a year with a rent review thrown in every 3-4 years. I am just going off what i have read in here for all of this so please seek professional advice, but it does look like a decent deal

 

[acer]

have spent $200K and are looking at another $5 - 600K to build. We can only build if we get a pre-construction tenant.

We have an interested national tenant, but they are after 10 +10 year lease - 12 weeks rent free (sounds like a lot) and suggesting a lease rate that would bring us a 10% return.

Rent reviews? How do you determine a schedule for increasing rent - is it just CPI? When do you factor in a market review ? Is 10 years + 10 good or too limiting given the stage the development is at?

The return is critical to the end value of your building. A good way to asssess this is to gross up the net rerurn, ie if your building will lease at 100,000, to an investor (who wants/expects a 10% return) the value of the investment is 1,000,000.00. This is rough guide but gives you close to resale value of leased/end product. Check what investors have paid for building in your area, your agent should have recent examples.

You should also be sourcing lease rates per sq metre for the type of bulding you are constructing. Eg your finished building is 1,000 sqm and adjacent building leased at 100.00 per sqm, then you should be leasing at close to 100.00 x 1000 = 100,000.00 per annum.

The 12 weeks rent free is more than reasonable for a pre lease to a national tenant. Dont discount the value the a NT will add to your site, many investors accept a lower return (hence pay a higher price) for investments with secure tenancy.

You should though be also asking for a 3-6month bond on the lease. Some owners demand 12 months but this is extreme and may deter tenants. If the proposed tenant is genuine thye should be placing a bond in trust pending occupation, failing this is to commence with risk.

10 year is excellent a it effectively ties you with a 10yr income stream, which the bank will love.......particualarly if the tenancy is strong.

To me the deal sounds a good one and the security of a national tenant on pre lease eliminates risk. I wouldnt want to lose the tenant by too harsh but would want some bond in place prior to any design / construct.

The only other issue I would concerned with is any design factors that tenant may demand.....this may greatly add to construction. Also, be aware that if they sign prelease and expect to be in by a set date, failure by you not to have building ready may incurre further costs/penalties, but these your solicitor would be chasing.

Good luck with this.

 

[KSTA]

I can see the light

Thanks Belu and acer,

I gathered that the concept of return is a fairly fluid - one that needs to be carefully defined. It was for this reason I wasn't sure if I was comparing apples with apples. I hadn't taken into consideration the effect of depreciation - it will help offset any rent free period.

Thank-you acer -as a novice my concern is finding the right balance when it comes to negotiating the lease. I think we have been very fortunate to get an interest in the project by a national tenant so quickly and didn't want to sell ourselves short or be too pigheaded and scare them away. We have had our mortgage broker suggest 3 months bond is standard for com/ind leases, he felt 12 weeks rent-free was a bit much - it will mean the property is negatively geared in it's first year - but I suppose you have to look at the fact that they are a bigger business and are offering a very long lease.

Lease rates - there isn't much available in the area - it's a new estate and have been given these figures on the advice of the broker and real estate agent we have been dealing with - we have had to muddle the figures a bit as on our 1900sqm site they only want a 600sqm building and the rest as dedicated hardstand to come up with an annual figure that assumes $120/m building and $45 for hardstand. We originally worked out that we could design a building that gave us just over 50% site coverage and then have several smaller tenancies - but our figures suggest that given the extra cost of a bigger building the overall return wouldn't be that much different and we'd have to find and deal with more tenants.

 

[DebtEquity]

I would be running it past a lawyer who may know more about leases and rent reviews. in my opinion!

 

[acer]

I would be running it past a lawyer who may know more about leases and rent reviews. in my opinion!

No doubt solicitor should oversee........but generally the terms such as CPI or set % increases, bonds etc are agreed to by the parties first. Solicitors ensure terms are legally binding in preparing the lease. From past experience asking a solicitor for such advice on such matters will cost $$ and may well include items that the tenant sees as OTP, hence jeopardising any deal.

Also, in NSW (not sure about other states), not all commercial leases need legal opinion, ie can be signed off without legal advice. Not advising this is bet practice, just that it is possible.

 

[BayView]

I think we have been very fortunate to get an interest in the project by a national tenant so quickly and didn't want to sell ourselves short or be too pigheaded and scare them away.

How did you attract the National Tenant to your site?

And, what is "hardstand"?

 

[JoannaK]

And, what is "hardstand"?

Hardstand is basically open, fenced, land for lease, generally used to store bulky goods on, eg: cars, scaffold etc

 

[KSTA]

Contacting National Tenant

LA Aussie - we engaged the services of a well known commerical real estate agent. We drove around lots of industrial estates and made a list of the businesses that we thought would be suitable for our site. With a little more confidence we would have cold canvassed businessesi.e. just asked them if they were interested in a new purpose built tenancy. Instead we noticed one that seemed to have built a number of new premises in the past year and suggested to the agent that they might be worth contacting.

 

[BayView]

Thanks KSTA and JoannaK.

 

[skater]

Do a search on Dazzling. He has many commercial/industrial properties & I recall him mentioning terms of his leases including rent reviews etc. Could be some valuable info there.

 

[Indifference]

I am relatively inexperienced, but have recently used the rent free concept to good effect to secure tenancy.

Additionally, it is not uncommon for tenants to pay outgoings for commercial properties. (maybe I am stating the obvious... sorry if I am) Mine is a multi occupancy, so the expenses are split accordingly. This is one area where Comm IPs start to shine above Resi in the return stakes.

Having the lease drawn up professionally and then the legal negotiations thereafter are somewhat more tedious (& expensive) then on Resi IPs, but how many houses are on a 10 + 10 yr lease? This is a good a security blanket given the right tenant.

As a first time Comm Prop investor, I couldn't be happier with my decision to take the plunge upon reflection of the past 3 yrs.

 

[shuggy]

To clarify a few points. The agent is a very experienced industrial/commerical real estate agent. Most of our figures regarding estimations for rent have come from him or our mortgage broker and are based on what is happening in the area. Both of these people are saying that the numbers stack up and to go for it. I guess trust is a problem of mine and I like to source information from a variety of places.

I think that's a good reason to be wary as these 2 guys are the ones who benefit financially once you sign the tenant up. They want their commissions, which is fair enough.

As I said in my first post we have been told we could get a 10% return and that this is based on the expected rental return divided by the price of the project - is this the correct definition ? I have read about people referring to x% net yield - is this the same thing? and if so is 10% an acceptable return for this sort of project ?

I don't know anything about commercial but i think acer has given you excellent advice. Research what similar leased buildings are returning for a ballpark figure. Then see if its close to the 10% return being mentioned. And then for the hell of it, make a counter offer of 12% and see how they react.

You can also give them a low bond in return for other things if you judge this national tenant to be a safe risk. If you don't think they'll trash your place, get concessions elsewhere.

I'm not sure about the 10+10 only because if population is increasing and prices really boom, then the value of your property goes down if your rent is not at market level. Sure its a 10% return today but in 10 years it could be a 5% return if prices double.

 

[skater]

I'm not sure about the 10+10 only because if population is increasing and prices really boom, then the value of your property goes down if your rent is not at market level. Sure its a 10% return today but in 10 years it could be a 5% return if prices double.

This should not be a problem if you have a ratchet clause in the lease. Look up Dazzlings posts. He has spelt it all out many times.

 

[acer]

This should not be a problem if you have a ratchet clause in the lease. Look up Dazzlings posts. He has spelt it all out many times.

The purpose of a ratchet clause is to ensure rents do not decrease at each rental review period. This may occur when rent reviews are directly linked to CPI, or based on open market rent at that time. The general assumption is that rents / CPI will increase each year, but a rent reduction would apply if the rent is simply linked to market / CPI figure (and there is a reduction in that figure). A ratchet clause ensures that the rent cannot reduce regardless of a negative scenario.

Ratchet clauses in NSW are common for industrial leases but illegal in retail leases. One way around this is problem is to stipulate a set % increase at review.

 

[KSTA]

Yield vs Return ?

Thank-you - I finally understand the importance of stipulating a % increase and not just leaving the rent CPI.

Acer - ratchet clause - nice simple explanation, now to get it accepted in the lease agreement.

I read an earlier thread about 'Yield' and people generally were saying they like a IP to get around 4 - 5%. I have also come across discussions about 'returns' with people saying it is getting harder to secure 10% returns on commercial IP - what is the difference ?

We are still negotiating and have just had our broker do a feasability study on the figures we have so far - OMG !!! So many numbers and acronyms. I guess there is nothing like a bit of pressure to force you to understand the ins and outs of property investment - if we hadn't actually bought the land I think I would have switched into analysis paralysis and opted for the old adage if you don't know, don't go strategy.

I will keep you posted on how we go

 

[acer]

Thank-you - I finally understand the importance of stipulating a % increase and not just leaving the rent CPI.

Acer - ratchet clause - nice simple explanation, now to get it accepted in the lease agreement.

I read an earlier thread about 'Yield' and people generally were saying they like a IP to get around 4 - 5%. I have also come across discussions about 'returns' with people saying it is getting harder to secure 10% returns on commercial IP - what is the difference ?

We are still negotiating and have just had our broker do a feasability study on the figures we have so far - OMG !!! So many numbers and acronyms. I guess there is nothing like a bit of pressure to force you to understand the ins and outs of property investment - if we hadn't actually bought the land I think I would have switched into analysis paralysis and opted for the old adage if you don't know, don't go strategy.

I will keep you posted on how we go

One last point relating to CPI / set increases......if set increases apply and inflation exceeds your stated figure, your actualluy behind. To overcome this terms such as "greater of CPI or 5%" maybe used.

Also set increases such as this are stated in the lease, eg CPI/5% each year to yr 5 then yr 6 "market review". The purpose of the 6th yr market review is ensure your lease can be measured against surrounding properties and if yours is set below comparable buildings, increased to that rate. When market review cuts in be aware that if surrounding rates have actually dropped (yes vacancies / economic downturn will impact) your ratchet clause would be applied - ensuring the rents never drop below previous rate. By building in the market review you have ensured that your building value will be protected as the area experiences increased demand, avoiding a reduced sale price due to rents not providing the required return. It does get complicated but your solicitor should be aware and will build in, just make sure you stipulate to tenant so that they are aware of your intent.

Dont be too concerned with "yeild" or "return". Both pretty much relate to what you are earning from your dollar invested, and should be expressed as a net figure (ie after all your holding costs such as known expenses are deducted from the figure). My experience guides me to expect a return of at least the cost of money (for an industrial investment). Retail maybe less. You need to calculate what the end product will cost you, then apply the required % return to that amount, to assess if your deal stacks up.

There are no set rules, if your building costs 1m and rents for 100k, then this is 10% and with depreciation you get additional benefit. It all depends on what you are willing to carry as many deals (in recent time) have been done at well under 10%, eg retail in sydney sells often at sub 5 - 6%. Again, if starting out it will be impossible to get it perfect first time so aim to get a secure tenant on a return that eliminates risk. What rate of return / yeild this means to you is a personal decision, but no one will question you if the return is 7% or if it is 12%. I see the issue being more of being able to hold the property comfortable and then hopefully profiting from the excess cash flow after expenses.

Another matter relating to yeild is outgoings. These need to be clarified in the lease, but there are no set rules. Items such as Rates, Building insurance, maintenance, land tax, even building management costs (and others that you becomne aware of) are up for negotiation and can be included as a cost to the tenant. If agreed to and included as an "outgoing" payable by tenant will be paid additional to the rent specified. These are major costs and you need to particularly consider insurance, this will be significant depending on the building use.....if not catered fop it may eat into your return. Get your agent to go through wht he expects to be your outgoings, and whats reasonable to include. Try to get most (if not all) paid by the tenant. I would suggest as a minimum that rates and building insurance are carried by the tenant. Others can be bonuses.

Please do your research as I dont want you to rely on my word or experience soley, much will be learned from actual involvement in the process. Remember much of this is negotiation, its all open to negotiation and some of the above is best practice.......your tenant or agent might not like hearing some.

Do get the agent (and solicitor) to further advise - your promting and raising of such issues ensures there is less chance of later surprise.

 

[kum yin lau]

Hi, Acer's comments are very good.

The lease agreement will give you the end value of the property. Working backwards, you can determine the total expected return if your costing is accurate. I don't know the level of efficiency that your husband can achieve but be aware that costs have a very nasty way of blowing out!

The good thing about the lease is that it should determine the TYPE of building & therefore the yield is built into the building cost.

The agent who brought you the tenant may be reliable enough to give you good service, specially if you have your own lawyer to oversee the details.

I trust my agent. I make sure he gets enough out of the deal to make it worthwhile his while to run around on my behalf. I make it a point to insist that it's a % of profits/return.

Good luck,
Kum Yin