Real Estate Investing, with Tony John

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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I had a phone call today from a man representing a sports arbitrage company. His company had sent me a brochure a week earlier, and this was a follow-up.

What is sports arbitrage, you might be asking? I certainly had no idea. Arbitrage is where you take advantage of pricing differences in different markets, buying in one and selling in another, to make a profit. Ideally, the transactions happen at the same time, making a risk-free profit. Sports arbitrage is doing it by placing bets on sporting events.

It was interesting to talk to him. He asked me which sport I followed. After I named a few sports which were out-of-season or for some other reason unsuitable, he steered me towards the Australian Open Tennis, which is on as I write this. I was surprised by this; surely he needn’t have bothered finding a sport I cared about - the whole point is that you don’t have to understand the sport or the contestants, you simply look for suitable odds. He could have picked a cock-fight in some remote Vietnamese village, for all I cared.

Anyway, he found a tennis match in progress, found two suitable sets of odds in different parts of the world, and showed how he could take $1000, place a bet in each market, then end up with either $1067 or $1064, depending on the outcome (a 6.7% or 6.4% return)

Easy money, hey? Only it’s not completely straight-forward. You need access to hundreds of online betting agencies, to find the mismatching odds. You can be sure that there will be other people or companies searching for exactly the same thing. because there’s a profit to be made. Then there are technical issues with losing some money on exchange rate conversions, making sure the bets are accepted at the same time, before odds change, not to mention the upper limits to how much bookkeepers will take before changing their odds, or refusing to take more bets. Plus his company took the first 5% profit for each transaction, so the actual returns promised were pretty small.

At the end of his explanation, he invited me to hand over $8000 and start an account with them. They would take care of everything else. This is where I said no, and we ended our call.

At least arbitrage is in theory risk-free. Some investment systems I find comical. One company was trying to sell me horse-gambling software. If I diligently typed in horse data - results, odds, and so on, from all the different venues, for weeks on end, it would tell me what bets to place. I remember explaining to the sales person: “I like commercial property, because I like the safety of a legally-enforceable lease”. She countered with “but this is as safe as commercial property”. I wondered what my bank would say if I tried put up my house as a 30% deposit, and borrow 70% to bet on horse-racing, explaining that it was just as safe as commercial property, and should therefore attract the same LVR.

I know someone investing in rare artwork. He expects to make a good capital gain, and thought I might be interested. I told him that he may well be right, but that I need cashflow in the meantime. I’m not investing to get some lump some at the end. I’m investing to get cashflow now. My lifestyle depends on my investments paying me money now.

I also know people who honestly believe their best chance of getting rich is to win the lottery.

I don’t know if I attract these people, or everyone gets this: I had a consultant come around to offer me a crop of trees. I wouldn’t get to own any land, just a certain number of trees, which would be cut down in about 10 years time. I was amazed at the low return. Yes, you would double your money over 10 years, but that worked out to be a pretty low rate of return. After his presentation about trees, he moved onto a questionaire, including the question “what rate of return would you like to receive?”

I thought about this. I’ve talked about how I like to make a rapid capital gaid soon after purchasing. I like to make my deposit back in the first year, equating to a 100% return of the money I put in. I thought that sounded a bit high, so I scaled it down and said “Probably 50%”.

“OK, 15%,” he said, writing earnestly into his questionaire. “No, 50%” I said. I wasn’t trying to be boastful, but he stopped writing, and looked at me to check if I was serious. When he realized that I was, he was gone within five minutes, and never did the follow-up call that he promised.

As long as it doesn’t take up too much of my time, I enjoy hearing about opportunities. Even if I’m going to say no, I like to understand it first, so I know what I’m saying no to. When people or companies offer me ways to make money, I generally listen, because it’s interesting to hear different approaches. I see what I can learn from them, evaluate them critically, looking for flaws in systems. For example, when I asked Tree-man what happened if a storm or fire destroyed my trees, he said I would get my money back. Get my money back! I would be devastated if after 10 years I got back what I put in! Talk about going backwards.

There are so many opportunities to put your money into different things. Thus far, I’ve always come away concluding: “I prefer real estate.” To be fair, I’ve only been talking about the more unusual types of investment here. What about the stock market?

This past year, I’ve been bombarded by the media, telling me again and again how much money everyone is making in the stock market (at least until the sub-prime issue dented prices somewhat).This is OK. I would need to undergo a massive education process to do well in stocks. I don’t have the expertise. If I went in without the expertise, I would be gambling. Fundamentally, I don’t like gambling.

When you hear all these different things, it’s tempting to move around, from one investment type to another, looking for that big return. The grass does often look greener elsewhere. Alternatively, you might try to put your money into everything at the same time, trying to cash in on all market sectors,. Instead you spread your money too thin and dilute your profits.

At this point in time, and for the foreseeable future, I’m very happy with my choice to stay with real estate. If the media tells me that others are making fortunes elsewhere, good luck to them. When I worry about what other people are doing, that’s when life becomes less peaceful for me.

If you don’t have one already, the sooner you can develop a very clear strategy for wealth creation, one that you can stick with, the better.

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I know this is supposed to be a blog about commercial property, and I’m getting there, I promise. But I’m going to continue about the sale of our residential property (hey, I’m on a roll). It does have general lessons which are relevant to commercial investing.

We bought with the plan of subdividing one block into four. But when we did detailed research, this turned out to be a bad plan. For all the reasons I explained yesterday, the retaining costs were astronomical, and we weren’t able to make money by subdivision. The main reason we bought the property turned out to be a bad one. What a disaster!

Our greatest fear had come true. Actually, it’s a collection of fears: the fear of making a mistake; the fear of doing something stupid; the fear of losing money; the fear that the naysayers, who told us that the sky will fall down, will be right (’I told you so’).

These fears are so powerful that they keep many out of property investment altogether. This is a shame.

Since I’ve been investing, I’ve done some dumb things. Some things I should have known were dumb. Other things, I couldn’t have known were dumb until I did them (Oscar Wilde: ‘Experience is the name every one gives to their mistakes’). I’ve learnt that when things go wrong, it’s not the end of the world. I’m still alive. I still have family and friends. Even when things go terribly wrong (like, when a tenant went broke owing us more than $40,000), it is not fatal.

Making a mistake with a property deal can be painful. But open any newspaper, any day of the week, and you will see that truly, there are worse things that can happen.

As it turned out, while we held our residential property, the market went ballistic, and we made more than ten times our money. Not a bad outcome for this property ‘disaster’.

So, do your research. Do as much as you can. But more importantly, have the courage to act and make mistakes. Otherwise, nothing will happen.

I was given a dictionary of quotations for Christmas, so if you’ll indulge me quoting General David Shoup: ‘The galleries are full of critics. They play no ball, they fight no fights. They make no mistakes because they attempt nothing. Down in the arena are the doers. They make mistakes because they try many things. The man who makes no mistakes lacks boldness and the spirit of adventure. He is the one who never tries anything. His is the brake on the wheel of progress. And yet it cannot be truly said he makes no mistakes, because his biggest mistake is the very fact that he tries nothing, does nothing, except criticize those who do things.’

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