Real Estate Investing, with Tony John

Today’s post will conclude my series of posts about tenant quality.

Let’s say you’ve got a good tenant, by luck or good management. Now what?

By corollary, if getting a better tenant makes your property more valuable, getting a worse tenant makes your property less valuable. So, it’s worth looking after a good tenant.

How do you look after a good tenant? You’ve already got a lease which guides you and the tenant about what you can and can’t do. For me, looking after a tenant means being flexible, and caring about the tenant’s business.

Examples:

• I had a tenant who had recently taken over a business (which had been running poorly), and was in the process of building it up again. She was finding the first few months tough, and a rent-review fell due. I could have raised her rent 5%, instead I raised it 2%. She was very grateful.

• I allowed a tenant to have a pizza oven installed, which required a new hole in the ceiling and roof. This was on the condition that he repair it all at the end of the lease. The pizza oven helps the business.

• Doing some cosmetic work to the grounds (garden), so the tenant’s business will look better.

None of these are required by the lease. I could say no to all of these things. But it pays to have a happy tenant, who is not whining or blaming you, the landlord, for problems in their business. It pays most of all to have a tenant who is reliable at paying rent.

What am I not willing to do for a tenant? Accept late rent or non-payment of rent. As soon as a tenant has problems paying rent, I want to talk with them. I want to find out whether it’s a one-off, or there’s a long-term problem. If there’s a long-term problem with the business, I don’t want them as a tenant!

Well, that’s enough about tenants for now. Starting tomorrow, I’m going to repost some articles I wrote some time ago - the original 5 parts of an introductory course on Commercial Real Estate Investment.

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I was saying yesterday that one of my properties became more valuable when I changed tenant. It didn’t become more valuable in a way that a valuer would recognize. The new tenant wouldn’t affect the official value. But the property became more valuable to me, because my life suddenly got easier and more enjoyable. Even though it’s hard to quantify, don’t underestimate how important that is.

When I met with the new tenant, I saw another real benefit straight away, and this will ultimately make me money.

You see, this is the property with a lot of extra land, which I want to break off and sell.

When I first mentioned subdivision to the old (angry) tenant, he essentially said: “I hope you don’t plan to subdivide the land. You can’t. I’ve had the lease checked, and my lawyers have confirmed that you can’t do it. My lease covers the entire block, so you can’t subdivide it, and if you start taking any action towards subdivision, I’ll fight you.”

Now, we checked this clause with our lawyers when we purchased the property. They told us that the subdivision clause was clearly intended to allow subdivision, but was badly worded and ambiguous. Not great, but quite different to the tenant’s stance on the issue.

Anyway, with the new tenant, when I mentioned subdivision, her response was very different. “Please!” she said, “I’m not using any of that land, but it costs me thousands of dollars on mowing and general maintenance. The sooner you can subdivide it, the better. I only want to manage the small piece of land my that the building is on.”

I don’t know exactly how much, or exactly when, but that difference in attitudes will make me money in the future - no doubt. Again, it doesn’t show up in an official valuation, but it’s worth a lot to me.

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I’m continuing the topic of tenant quality today. I’ve been describing how I was extremely happy to get a new tenant for one of my properties.

I feel this way because the previous tenant was, well, difficult, to put it politely. Oh, he ran the business profitably and always paid rent on time. You would think that made him the perfect tenant. But he wasn’t. He was unpleasant to deal with.

Now, business is business, and you might think that values such as being pleasant don’t count for much. But it can count a lot. See, you can get things done easier, quicker, and cheaper when you have a cooperative tenant. It’s hard to get anything done in an atmosphere of dislike, distrust, or where there’s a willingness to involve lawyers at the first opportunity.

The problems with this tenant started a long time before I came on the scene. By the time I purchased the property, there was an escalating fight in progress between the tenant and the previous owner. In summary:

• the lease said that the tenant had to paint the building. The tenant refused. When the tenant refused, the owner started sending the legal notices. The tenant went to his own lawyer, and soon enough expensive legal letters flew back and forth.

• a few months later, the building still was not painted. The lease said that when the owner incurs legal costs, enforcing the lease, then the tenant must pay them (commercial leases generally favour the landlord like this). So, the tenant got a bill for all the legal costs. The tenant refused to pay these costs. Things were getting nasty, and all over a coat of paint. The legal costs had become much higher than the cost of painting, but that’s how silly people can get when they’re angry.

• towards the end, every time the owners wanted to inspect the building, the tenant refused to let them on the property. Ultimately, the owners had to get police to escort them onto the property, so they could safely inspect the property without interference from the tenant.

• there were other similar issues, about carpets, general maintenance, and so on. Nothing went smoothly. There was no goodwill on either side. Everything ended up in a fight.

Sure, eventually, with enough legal procedures, the tenant would either have to comply with the lease, or be evicted. But the cost for the owners, both financial and in terms of peace-of-mind, was huge. In fact, I’m sure this is why they put the property on the market. By the time we came along, they were very keen to sell. This property was supposed to be an investment which looked after the owners in retirement. But they were not enjoying retirement. They were stressed, and simply tired of the whole thing. They wanted out. So I bought it.

One of the problems with this property is that by the time I purchased it, the tenant was no longer on speaking terms with the property manager. There was a poisonous relationship, which was no good to anyone. So I decided I would manage this property myself. I have some training in customer service, so I felt I would be able to resolve conflict better than the previous owners. Well, my skills were tested to the limit! Sure enough, within a month, the tenant was on the phone, furious over some matter. The matter itself was a fairly minor misunderstanding, which, with most people, would be resolved in about one minute. But not this guy. He was what I would call disproportionately angry. He reminded me of those people you read about who in a road rage attack will kill someone over changing lanes without indicating. With my training, I was able to resolve the problem in a way that satisfied him, and he ended up apologizing for getting so angry. So we kept our working relationship, but things weren’t easy.

Fortunately for me, soon afterwards, that tenant decided to sell the business. Most people assumed that he enjoyed fights, since he would get into them so often, but I guess the fighting must have been causing stress for him as well.

He sold his business to one of his employees. This was a perfect opportunity to make a fresh start. In my book, it was worth flying for two hours each way just to meet them for fifteen minutes. Business is based on relationships, and I think it makes an enormous difference to actually meet the people you’re talking to.

The meeting went well. Just about everything the new tenant said was music to my ears. For example, she told me: “I’m Italian, and was brought up to look after something, whether it belongs to you or not. Now there are some improvements I’d like to make to your property, that I want to talk to you about. I want to repaint this room, install new powerpoints here, …”

What a breath of fresh air! Here is someone who is not looking for a fight. Instead, they want to have a good relationship, based on mutual respect and goodwill.

This doesn’t show up on any balance sheet. If I was getting the property valued, I would expect the value to come in the same, with either tenant. But it’s worth a lot more to me now, because I don’t have to spend my time, money, and energy on fighting.

And guess what? Because she’s so much nicer to deal with, the business is doing a lot better since she took over. Customers are flooding back - almost more than she can handle. She’s making more money, and can more easily pay the rent. Everybody wins.

I’m happy when the world works out this way.

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I previously explained how the quality of your tenant can affect your property value. This happens when a valuer (and presumably, the market), can see that you have a better, more secure, more reliable tenant, and decides that the property is worth paying more for. People will pay more to get a lower risk. That’s why we have a different capitalization rates in different areas.

Why do we care about this? Because a higher valuation gives you greater equity, which makes it easier to buy your next property. I keep drumming that in, because it’s so important to keep remembering why we care about this.

But you know what? Tenant quality is even more important than that. There are intangible benefits to having a good tenant. These benefits may not be reflected in a valuation report. They may not affect the value of your property to the outside world. But they sure make a difference to your life.

I’ve had two commercial properties with struggling tenants. Both of them fell behind in their rent payments.

On a human level, these stories are very sad. Nobody wants to fall behind in their payments. These tenants are not bums, they are trying to be responsible members of the business community. They bought the business with high hopes of making good money. But now they are making a loss, for whatever reason. When you meet them, you can see the signs of stress and shame in their face.

At a business level, the situation is a disaster that can not be allowed to continue. I rely on their rents to pay interest to the bank. If they don’t pay, I risk becoming the same as them, unable to meet my financial obligations to the bank.

Both times, I found myself worrying. Worrying whether they would pay rent. Worrying whether I could pay my interest bill. Worrying if I would need to find a new tenant, and whether I could afford an empty building. A struggling tenant affected my peace-of-mind.

In the end, both tenants ended up selling their businesses, and moving on in life. One paid me back completely what he owed, the other paid me back 30 cents in the dollar.

Luckily, the new owners of both businesses are thriving. The new tenants have never missed a rent payment, are profitable, and are happy.

The benefit to me is that I know that I will be paid each month. I don’t lie awake, wondering what will happen if they don’t pay rent. This is a huge benefit to me. Having a tenant that you worry about is a real drain, mentally. Replacing a struggling tenant with a good operator, who you can rely on, makes a big difference to the quality of your life.

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I was looking through one of my Valuation Reports the other day, and found a nice quote which demonstrates how valuers evaluate commercial real estate.

“Well located suburban properties, securely leased to national tenants, with modern building improvements, represent prime property investments and sell on yields of between 6.5% and 8.0%. These properties are in very strong demand with an oversupply of buyers and an undersupply of stock for sale.

Properties that do not possess all of these attributes but have reasonable lease covenants of say 5 years, are selling on returns of 8.5% to 9.5%, depending upon location and building quality. There has been generally good demand for these investment properties.”

Now, your mileage will vary - the numbers themselves will change from region to region. But the key is this: a better quality tenant will give you a more valuable property.

You see, it’s all about risk.

With a big, national company, your tenant has a strong financial backing, which means you can have a lot of confidence in your income.

With a smaller tenant, no matter how well-intentioned or business-smart they are, there is inherently more risk. One big lawsuit, one marital split, one fraudulent employee, or some unexpected occurrence, and their business (consequently, your income) is under threat.

People are willing to pay more for a lower risk.

Back to my valuation report. The valuer went on to value my property using a capitalization rate of 8.75%. This reflected the fact that my property had a single, independent operator.

Now, I’ve got a chance to re-lease the building, and I’m going after a national tenant.

Here’s the math, assuming the valuer chooses the mid-point of the respective ranges:

Let’s say my property brings in $50,000 per year in rent.

With a lower-quality tenant, my property gets valued with a capitalization rate of 9%, giving it a value of $556,000.

With a national tenant, my property gets valued with a capitalization rate of 7.25%, giving it a value of $690,000.

So, switching from a standard, independent tenant, to a strong national tenant will make me $134,000. Even if the rent doesn’t change at all. That’s a massive difference! Makes it worth acquiring a good tenant, doesn’t it?

Some people are surprised by this. It’s the same land. It’s the same building. Surely the value can’t just change like that? What you have to remember is that a buyer doesn’t just buy the land and building. They also acquire the tenant and the lease. That’s why the value of a commercial property can change so significantly overnight.

Tenant Quality Affects Property Value!

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I flew across to one of my properties this week, and met the new tenant for the first time. The new tenant struck me as a delightful person: enthusiastic, motivated, smart, and respectful. It made me think about tenant quality. But before I start this topic, I’m going to repost a relevant article from my old site…

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