Commercial Property - $4.5m Purchase

I expressed interest in some commercial real estate a little while ago so I receive brochures in the mail periodically. The following property in StKilda Melbourne picked my interest.

Have never bought commercial property, but plan do so (nothing as big as this initially) so are starting to learn the ropes. With a view to improving my knowledge, I thought I would give a brief assessment and some observations on this property, write down the key issues as I see it, and throw it out to the PC community to get some answers. Most importantly, I want to know ‘What have I missed’? What are the steps you would go through if you purchased a property like this? What do you think of this property as an investment - good or bad? How would you go about structuring and stitching together a deal to buy this property? (Had a stab at it below - feel free to pick it apart).

Would welcome replies to just one or two particular questions based on your expertise (don’t feel need to respond to all) or where you think I have missed the mark? - eg Nice question, but you forgot about this, this, and this which is far more important.

1. I know the area quite well, having lived in and around StKilda for a substantial part of my life. Have probably driven or walked past this property about 50 times. Knowing the area well is a plus when purchasing. This property is near the corner of Grey St and Fitzroy St so it is an expensive area generally, albeit with a real gritty and grungy element that often attracts visitors to the area.
2. I note that the main areas of Fitzroy and Acland St have a high turnover of businesses and some shop fronts are vacant for long periods. In Acland St, I speak to the shop owners from time to time (cake shops in particular which Acland St is famous for) and they all grumble about the rents. Small cake shops rent for about $4k per week they tell me so we are talking premium rents. Grey St is in StKilda but a somewhat different vibe to Acland St and also Fitzroy St. In terms of ranking, I would rank Acland St as number 1, Fitzroy St number 2 and Grey St number 3 in terms of basic retail space.
3. The property has total income of $231,000 pa + GST. If you assumed the property will sell for a yield of ~5%, that equates to a sale price of ~$4.5m. Is a yield of 5% realistic for this type of area and this type of property. In the StKilda area, most residential property rents for sub 3% yields. What type of yield would you target for a property like this?
4. This property would carry less risk than a large commercial property in the suburbs given the unique nature of the property and the location, and would carry less risk given the number of tenants in the building (you are not reliant on single tenant, and the location is unique). Agree?
5. When I look at the property and location, my immediate thought is that an investor would buy this property, keep the tenants in place for a period of time, but long term, you would seek to develop the land and build multi-unit apartment block. There is a lot of development going on in the area, albeit it has slowed somewhat given the general slowing of the property market.
6. Financing? Have only ever purchased residential, so how would you go about financing a property like this. My first thought : approach the Bank with an existing close to debt free residential property (say $1.5m value) and pledge as security for a $4.5m loan. So, a $4.5m loan on a $6.0m asset base (residential property + commercial property) is a LVR of 75%. Brokers out there in PC land, is getting a $4.5m loan achievable in the current lending environment for a property like this? Or should one be aiming for a LVR closer to 65% (or 50%) to get a deal like this away? I know this is a difficult question to answer without all the facts, but just want high level view. Particularly interested in knowing whether a LVR of 75% on a property a show stopper in current environment?
7. Is this property classed as commercial? So forget about getting an interest rate close to 4-4.4%. What would you target for an IO loan in current market?
8. What banks would brokers naturally approach for a deal like this? For large amounts like $4.5m, is it better to go to one of the big 4 rather than the smaller players? I am just trying to get a feel for this.
9. Having only ever purchased residential property, this would clearly not be the first deal re CP. I am all for starting small, getting some runs on the board, and building up to the point where you can purchase a property like this. Probably start at $500k, then maybe $1m and then work from there. Agree?
10. An even harder question. A person purchasing a property like this would need a substantial net worth and conservative gearing. To have some chance of getting a deal like this away, I am thinking you need to approach a bank with an asset base of $15m, equity $10m (assume all residential and roughly neutral cash fliw after costs, plus applicant has substantial PAYG income)? Or does the PC community think this is just unrealistic and you need close to $15m net worth to try and take on a deal like this? (Just want to test people’s 6 sense of what is required).
11. In thinking about developing the property, you would need a good understanding of zoning laws. I see it is Commercial 1 Zone. How would you go about assessing the ability to getting planning approval for the development I mentioned? Is there an element of, just buy, rent it out, and then think about development options down the track? I would see the development as almost a Stage 2 thing. Stage 1 is buy the property, bed the deal down, ensure the tenants are viable, and quite frankly, just scrimp and save and work like hell to reduce the LVR. Once that is done, then think about Stage 2 (maybe after 5 to 10 years). In other words, break deals down. Don’t try to eat the elephant on the first bite. First stage is to shoot the elephant, making sure you don’t get killed in the process.
12. The property is going to public auction in just under 3 weeks. How confident would you be of getting finance arranged in that period? My sense is that 3 weeks is not enough time to get a deal like this up, other than for those with substantial assets and very large lines of credit (for this example, assume the purchaser has reasonable income and assets and would need to work hard to stitch the deal together). In which case, relying on flyers in the mail is probably not going to do it. Suggests you almost need a relationship with a commercial real estate agent who can give an early heads up on approaching sales?
13. What are the mechanics of buying a property like this? It is a public auction, so you cannot put a bid in ‘subject to finance’. So, that is a show stopper as I see it. Given the complexity of arranging finance, I would never make an offer on a property like this without a ‘subject to finance’ clause. So, how would you address that?
14. What due diligence would you do on the lease arrangements. Review each of the leases with a lawyer? I assume the agent would provide these to prospective purchasers? Is there something equivalent to the s32 process (Vic) for commercial real estate?

I am in learning mode, so any thoughts and feedback would be greatly appreciated.


All the best for now.

 

A few thoughts on the back of a napkin

1) 231k off 4.5m isnt exactly stellar unless they are top quality tenants

2) 4.5m will require about 2.2m cash put in by purchaser

3) If you were to have 50% vacancy could you afford to pay the mortgage on 2.5m for a year or two as well as fund any refurb/lease incentives

 

Thanks Dave, I think this will sell for a low yield given the unique location. My sense is you are right right on the LVR. Need to be aiming to put $2.25m (1/2 purchase price) to make deal happen. This is not first home buyer 80% LVR stuff.

 

So, you would need a good cash buffer for (among other things) lease incentives is a tenant vacated? Another question: I assume suing a tenant that breaks lease and vacates early (assume the business went bust) is generally not a viable strategy for recovering money?

 

Good questions/analysis, Interested to hear responses from more knowlegeable people on some of these too.

Regards to question 5 - I'm not familiar with the area but the building looks heritage, I think you would need to understand any protections in place if thinking about future redevelopment.

 

- Lease incentives (fitout, refurb, lobby upgrades etc
- Capital improvement (reroofing etc)
- Maintenance (a building like that could easily eat 50k pa in maintenance costs from your gross lease income)
- Vacancy

Depends on what security was held (cash bond, bank guarantee, personal guarantee) and if the personal guarantee is worth anything based on the tenants assets

You can get commercial landlord insurance to cover similar to resi, but its a lot less inclusive

 

• Is the rent nett or gross?
• $210k/610m² = $378/m². This appears to be on the low side. Your calcs should be done on current market rent which will hammer the yield.
• What is hampering the rent reviews?
• Understand the planning controls - what is the development potential? Is it maxed out or can you undertake limited redevelopment if affected by heritage?
• Don't discount the site for development - so your comparison calcs on development potential

 

I think this is right. In that area, the payoff really comes if you can develop the site for residential and do 20 units. Maybe there is potential to build multi story and retain the facade to address heritage issues.

 

Great comments. Thanks. Regarding your point about calling some or all of the loan in. Is it standard practice with commercial loans to provide for calling in of loans if particular adverse events occur. For resi, once you settle on the loan, you never really hear from the bank provided loan repayments are made on time. Are there standard clauses in commercial loans that banks will not budge from that makes borrowing more risky.

 

Appears banks value income over net assets. A 40% LVR with modest income does not beat

When leasing a commercial property to a tenant, would you normally ask for a personal guarantee from the tenant if operating as a company (with no real company assets). Perhaps just depends relative bargaining power and uniqueness of the site whether a tenant would agree.

 

I note that the land area is only 465 SQM with a total building area of 610 SQM. So conversion to some residential may yield some return but large profits would be in redeveloping as multi story. So key to this deal is that development question.

 

Yuk. So it is not one of those nice standard letters, but straight from the external law firm? So to resolve, you generally need to tip in some money. With multi tenant arrangement, more manageable, but with a single large tenant (who goes broke and vacates) it really is good night.

 

Directors' guarantees, indemnities and larger bank guarantees all used to mitigate risk.