Leveraging Up...

[steveadl]

People always wonder why Tenants who pay cashflow positive rents simply don't buy the property themselves and tear up the Lease.

There is a multitude of reasons why, but the biggest one seems to be that in their opinion, their capital can be better employed in their business to earn greater money for the organisation.

Whether that belief turns out to be true or not is a matter for the future....

I have posed that very notion to many CFO's in organisations. I'd reckon about 80 to 85% all say it's a complete waste of capital to purchase the premises they operate out of, and would rather claim an instant tax deduction for all of the rent they pay in the year they pay it.

Only a very few support the notion of purchasing the premises, and they weigh in with things such as stability and a feeling of belonging, which obviously cannot be put into a cell on their spreadsheet. In the long run though, when they do, all of the young accountants coming through normally go "phew, they were wise to buy the place way back when for such a tiny sum....not having to pay rent sure does help the organisation in the lean times".

When it comes to business financials, I reckon it's hard task for management to make a property deal stack up. There would no doubt be great benefit in the longer term ownership of business premises, especially 10yrs down the track when the rents tripled.

Problem is, management have to justify their financial decisions and resulting impacts in the present day - not 10yrs from now. This is especially so if they're open to the scrutiny of being a public company. Private co's have more leeway depending on the owners opinion, but it's still a question of dollars now vs dollars later.

Whilst the purchase of the land and building may look good over a 10yr period, if management can instead earn 20% ROI on that same capital this year and for the next few financial years - they're going to be hard pressed to instead spend that capital/debt on the property which may only show a decent positive outcome for a 5-10 years.

'Hey Jim, why did we buy our warehouse property in the docklands for $10M last year when instead we could have commenced operations and built customer bases in Indonesia, Japan and Korea with that same amount of capital?'

Just my two cents.

 

[Dazz]

Exactly right Steve,


It all seems to boil down to the notion of DCF 'discounted cashflow'.


When accountants project out the values 15 or 20 years, those amounts become irrelevant when considered from the viewpoint of year 0. The discounting factor is so large out into the far future, that it may as well be zero. Slide the clock forward 15 years, and suddenly it becomes massively important.


HOWEVER, 20 years down the track, they become highly relevant when you are standing in that fully paid off Docklands warehouse cruising through the troughs of a business cycle when your neighbours / competitors are struggling big time under the impost of their large rent bill.


As I said, it all boils down to the attitude of the head knob accountant, usually the CFO of the big organisations. Most go the DCF route and appease shareholders in the year they are in. IMHO, the wiser ones bite the bullet and temporarily upset their shareholders for immeasurable security and long term better cashflows.


I don't believe the accountant's DCF models truly can take into account what actually happens 15 or 20 years down the track - especially when such large factors as wholesale personnel changeout in the company and growth / rent factors are such a big unknown.

 

[steveadl]

Yup, for the big co's the CFO's/accountants etc get in the way.

For the small co's, the banks get in the way. (I'd love to buy my building!)

 

[Aaron Sice]

i've always wondered why someone doesn't set up a corporate structure whereby a discretionary trust owns the building (with the trustee(S) being the business owners) and then use the pty ltd to rent it out?

that way, you get the rent as a claim back on one side and the depreciation and CG on the other....

 

[bene313]

i've always wondered why someone doesn't set up a corporate structure whereby a discretionary trust owns the building (with the trustee(S) being the business owners) and then use the pty ltd to rent it out?

that way, you get the rent as a claim back on one side and the depreciation and CG on the other....

What do you mean, related trust owns building and rents to business owner? This is common. Becoming more common is where the business owners pay rent to their SMSF(s), which holds the property.

 

[Aaron Sice]

What do you mean, related trust owns building and rents to business owner? This is common. Becoming more common is where the business owners pay rent to their SMSF(s), which holds the property.

yes spot on.

 

[tgarthe]

Exactly right Steve,


It all seems to boil down to the notion of DCF 'discounted cashflow'.


When accountants project out the values 15 or 20 years, those amounts become irrelevant when considered from the viewpoint of year 0. The discounting factor is so large out into the far future, that it may as well be zero. Slide the clock forward 15 years, and suddenly it becomes massively important.


HOWEVER, 20 years down the track, they become highly relevant when you are standing in that fully paid off Docklands warehouse cruising through the troughs of a business cycle when your neighbours / competitors are struggling big time under the impost of their large rent bill.


As I said, it all boils down to the attitude of the head knob accountant, usually the CFO of the big organisations. Most go the DCF route and appease shareholders in the year they are in. IMHO, the wiser ones bite the bullet and temporarily upset their shareholders for immeasurable security and long term better cashflows.


I don't believe the accountant's DCF models truly can take into account what actually happens 15 or 20 years down the track - especially when such large factors as wholesale personnel changeout in the company and growth / rent factors are such a big unknown.

I'm a management accountant, but not at CFO level. Adding to what Dazz said about capital allocation earlier, I think the idea usually gets scrapped pretty quickly as it reduces flexibiilty if you have to upscale/downsize etc.?Also the notion of dealing in 'non-core' business activities as well even if it does make sense. A lot depends on industry as well I suppose.

 

[Dazz]

Adding to what Dazz said about capital allocation earlier, I think the idea usually gets scrapped pretty quickly as it reduces flexibiilty if you have to upscale/downsize etc.?Also the notion of dealing in 'non-core' business activities as well even if it does make sense.

There's nothing I like more than meeting a CFO and eventually doing a deal with them to assist them to not invest in "non-core" business. I love 'em, you only need to find a few like that and it'll set you up for life. Bewdiful.

 

[Ausprop]

I'm an accountant and I don't get it... we've got some noddies that were paying $90k a year in rent when they could have owned it for $62k. they love the place and want to stay indefinitely, however their rent is now $150k. they still wont buy it.

say what you want but that's just stupid business. the only thing I an think if is they don't have the deposit. maybe...

 

[Joe D]

I'm an accountant and I don't get it... we've got some noddies that were paying $90k a year in rent when they could have owned it for $62k. they love the place and want to stay indefinitely, however their rent is now $150k. they still wont buy it.

So I assume you bought it instead?

 

[Ausprop]

So I assume you bought it instead?

yeh we have been the owners all along. has been a real eye opener on the power of comm over resi

 

[JIT]

say what you want but that's just stupid business. the only thing I an think if is they don't have the deposit. maybe...

I spoke to the Partners of the business I work in recently, where they lease 6 premises for their business operations and have plans to expand to a further 5-6 sites (all leased) in the next few years.

What they told me was that although it made sense to own the building, and that they could afford the interest payments, they didn't have the capital to allocate to a 30% deposit + costs on a CIP.

And also, that at the moment any capital they did have was better allocated to re-investing into the business and its growth rather than into holding other passive assets.

I think this mindset is great for those of us who are/want to be passive CIP investors.

These guys each own their own PPOR and a RIP or two, but no other hard assets of note as such.

I think that RIPs are still a good base to generate those deposits for CIPs: it's highly leveraged, with low interest rates, passive and tax-effective.

+ve Cash flow is great, but unless it's huge, it's not necessarily the best way to fund CIP deposits as you are using after-tax money.

So strategically I think starting out with RIPs still makes sense, you just have to be very good with your property selection, timing, and management of interest rates, and contain the negative gearing losses as best as you can.

And with any business, there's always the chance that it won't be worth anything after all those years of hard work due to strategic errors or competitive threats etc..., so accumulating some hard assets along the way is always a good move.

Having said that, I think the returns from a successful business would trump that from any RIP or CIP investment by a mile, but with much, much higher risks.

 

[Ausprop]

it's a fair comment JIT. where I am involved in at the moment the focus is on generating a large revenue stream that can be sold on at multiple. the big picure is multi millions, not a 1 million dollar property. one is a safe secure path, the other is seekign somehtign riskier and more fragile. I agree the opportunities for different participants are exciting

 

[JIT]

it's a fair comment JIT. where I am involved in at the moment the focus is on generating a large revenue stream that can be sold on at multiple. the big picure is multi millions, not a 1 million dollar property. one is a safe secure path, the other is seekign somehtign riskier and more fragile. I agree the opportunities for different participants are exciting

Exactly, the exit strategy for these guys I work with are to sell to a larger entity (either a listed group or larger privately held group) in the same industry at 5-6x earnings. If they pull it off they well be laughing, but otherwise, could be left with not much to show for it.

 

[Dazz]

I think the returns from a successful business would trump that from any RIP or CIP investment by a mile, but with much, much higher risks.

....true to some extent but I don't believe you are comparing apples with apples....

The business is active, it needs your constant input. No constant input, especially at crucial times working up to 16 or 18 hours per day to get some big event over the line and it all falls apart.

Holding CIPs is passive. One email a month per Tenant to send the invoice isn't very taxing on your time. A 100m portfolio can be done in less than 30 minutes.

 

[JIT]

....true to some extent but I don't believe you are comparing apples with apples....

The business is active, it needs your constant input. No constant input, especially at crucial times working up to 16 or 18 hours per day to get some big event over the line and it all falls apart.

Holding CIPs is passive. One email a month per Tenant to send the invoice isn't very taxing on your time. A 100m portfolio can be done in less than 30 minutes.

You're absolutely right, more risks and more time.

I'd pick the more passive option as my main focus for sure...

Your "risk/time - adjusted returns" would possibly be better with the passive CIPs.

 

[HiEquity]

Seen any scary looking big fins circling yet ??

Hi Dazz

Not yet. All quiet on the western front all of a sudden. You could hear a pin drop...

When accountants project out the values 15 or 20 years, those amounts become irrelevant when considered from the viewpoint of year 0. The discounting factor is so large out into the far future, that it may as well be zero. Slide the clock forward 15 years, and suddenly it becomes massively important.

There's no way you would ever build a Panama canal using a DCF model. Revenues which will be significantly valuable in 100 years time have practically no value at all in a DCF model. Fortunately in the past choices around the development of large scale infrastructure weren't conducted using a DCF model...

Unfortunately for the present though - very few accountants are willing or able to look past the DCF spreadsheet.

I think that RIPs are still a good base to generate those deposits for CIPs: it's highly leveraged, with low interest rates, passive and tax-effective.

+ve Cash flow is great, but unless it's huge, it's not necessarily the best way to fund CIP deposits as you are using after-tax money.

So strategically I think starting out with RIPs still makes sense, you just have to be very good with your property selection, timing, and management of interest rates, and contain the negative gearing losses as best as you can.

Hi JIT

I don't buy that CIPs grow less than RIPs - some properties grow more than others for sure but they exist in both camps. So to me the only advantage of RIPs when starting out is greater leverage (higher IRs are irrelevant if compensated for with higher yields). And that leverage advantage only applies if you get some capital growth in the first few years, which may not necessarily occur. If it doesn't, the superior cash flow from CIPs will swamp that advantage.

So I'm not as confident that a RIP strategy when starting out is the best one - it may be for some but certainly isn't for everyone. Depends on income levels, properties purchased, tenants, location, etc etc etc

Holding CIPs is passive. One email a month per Tenant to send the invoice isn't very taxing on your time. A 100m portfolio can be done in less than 30 minutes.

Except I guess when you're the one mowing the lawns, dealing with the security issues and fixing the retic?

 

[Aaron Sice]

So I'm not as confident that a RIP strategy when starting out is the best one - it may be for some but certainly isn't for everyone. Depends on income levels, properties purchased, tenants, location, etc etc etc

unless you're successfully targeting and exploiting niches in the market, i would agree with the above statement.

 

[HiEquity]

unless you're successfully targeting and exploiting niches in the market, i would agree with the above statement.

Hi Aaron

Fair enough but I guess I was thinking there are at least as many niches like this in the CIP market as there are in RIPs. There are an awful lot of developers who have made an awful lot of money in such niches within the CIP market...

 

[Dazz]

Except I guess when you're the one mowing the lawns, dealing with the security issues and fixing the retic?

.....yes, well, that's called "knowing and learning thy retail No No lesson"....never again.


It's similar to driving down a road saying "hmmm, that's a big pothole - best not to drive into that" then on the way home when you've already registered that lesson, you seem to drive into it just to see how bad the pothole really was....


My father and I were sitting out there having lunch in the park opposite, after having repaired 9 things in the morning that had been smashed, only to discover another 6 things vilfully smashed since last week. We both agreed retail was like residential on steroids and what the hell were we thinking buying this ******* heap of ****.


If you want to be kept busy and earn no money, then retail property is an excellent investment vehicle....similar to a one cylinder moped with square wheels - it's a vehicle alright but ain't quite smooth. This wood-duck carry on can be for some other sucker.


We are both looking forward to dumping the jalopy and getting back into our road trains and rolling back down the ultra slick industrial and commercial freeway of wealth.