Examples of Capital deals

1. Own the property you live in or the commercial property you work from

The property you live in or the commercial property you work from is not a capital deal in the strict sense of my definition above. Whereas capital deals are deals into which you enter knowing that your objective is to make a capital profit as soon as possible, the property you live in or the commercial property you work from is a deal you enter into with the objective of making a capital gain over a medium- to long-term period.

For me, renting means paying someone else’s bond when you could be paying your own. I believe that owning the property you live or the commercial property you work from is the easiest and most risk-free way to make money, for a number of reasons.

• Banks will more readily lend you money to buy your own home or commercial property as opposed to financing property investors and or speculators (particularly in slow market conditions)
• Provided that you buy the roof over your head within your means and within your budget, the money you spend repaying your bond every month is money you would have wasted paying rent to someone else.
• If you sell the property, you get 100 per cent of the profits after settling the outstanding bond on the property. If you rent you get zero profits at the end of the lease.
• Any improvements you make to the property translate into more profits when you sell. Any improvements you make to your rental property translate into profits for the landlord.
• If you are not able to sell your property you are not at risk because you still need a place to live or work. Selling your property is therefore a bonus and not a necessity.

2. Do (residential) buy/sell deals and buy/renovate/sell deals

When the timing is right there is no quicker way to make money out of property than doing deals of this nature. But if you get the timing wrong you could find yourself in a financial twist.

To time deals of this nature successfully is to get in and out of them as quickly as possible in a rising market. The more often you can get in and out during a rising market the more money you will make.

In my experience knowing when to get out is far more challenging than knowing when to get in. When you are making heaps of money, it is sometimes easy to ignore the rain clouds approaching in the distance. This is why I advise investors to get in and get out as quickly as possible even if at the time you exit a deal the market is still positive and you believe that you can keep going with another deal or two. The problem with market changes is that they can catch you off guard and that they can happen far more quickly than you think.

The most important aspect of getting buy/sell and buy/renovate/sell deals right is getting the numbers right. If you pay too much or fail to take into consideration the myriad of costs associated with buying-selling or buying-renovating-selling property you may make yourself a handsome loss on the deal.

If you have an inbred fear of numbers you need not panic. Property maths is not rocket science, and provided you know how to add and subtract you should be fine. There are many costs associated with doing property deals, and the difficult part of getting a deal right is not the maths but rather knowing what needs to be subtracted from the potential selling price of the property to establish a profit.

To assist you click onto Do the numbers under the Assessing Deals section of the website and you will find a calculation tool that has been put together specifically to assist you in doing the numbers on buy/renovate/sell deals. Although this calculation tool should never replace the professional input of a quantity surveyor, it does provide a useful snapshot of whether or not you can make the deal work and, most importantly, what price you should pay for the property. Once you have accessed the calculation tool, follow the prompts under each step of the process, and the calculation tool will take all the information entered and produce two reports, The Loan Amortization/Cash Flow Analysis Report and the Deal Summary Report.

The Loan Amortization/Cash Flow Analysis Report calculates the complete net cash outflow for the project from the date that you take transfer of the property to the date that you transfer it to the new owner. The net cash outflow includes bond and non-bond payments relating to the property deal.   The Deal Summary Report itemises all the upfront costs and total holding costs for the project. It further calculates the profit and loss on the deal as well as your return on cost, return on equity, and a break-even selling price for the property.

If the thought of bringing a full-scale property development to market is too daunting there is another way to make potentially huge profits without getting your hands dirty.

In the property-development game there are two stages to every development. Stage one involves tying up the property with the seller, putting a development scheme together and obtaining the necessary planning permission and rights from the relevant authorities. Stage two involves selling the scheme to end purchasers, completing the construction and dealing with the hand-over to end purchasers, including the handling of snags and related issues.

There are a number of property developers, particularly those who have their own construction crews, who do not want to put the time and effort into putting schemes together and procuring the necessary rights from the relevant authorities. These developers are happy to take over schemes with established rights and pay a premium for the land so that they can get their team to work.

If you follow this option please take note of the following:

• There are absolutely no guarantees in the property game that you will be granted the change of use rights or be allowed to establish rights for a development. This means that you should never ever buy land in the hope that the rights may be granted. If the rights are not granted you will be sitting on a useless piece of land that no one wants to buy. In Chapter 7 of my book Fast Forward your Retirement through Property [Zebra Press: 2009] you will learn how to use suspensive conditions in the offer to purchase to ensure that you only commit to property deals once the required rights are in place.
• On the timing front you need to be careful of embarking on deals of this nature in a rising market that may be reaching its peak. Given that the timing of the process is long and unpredictable you may start the application in a booming market and be granted the rights in a flat market, making the property very difficult to sell despite the established rights.

On a smaller scale, a number of property investors have applied the use-rights idea to the home in which they live. For example, if you buy a property with a large garden you may be successful in applying to subdivide the property and sell the garden to another purchaser. Other investors have deliberately bought cheap family homes on busy roads with established businesses with the intention of rezoning the property for commercial use. Such a property with commercial rights in place may be worth far more on resale than a property with residential rights only.

5. Buy/sell commercial property deals (Experienced investors only)

There are untold fortunes to be made by savvy and experienced property investors who are able to buy commercial properties at high yields and sell them at low yields in a short space of time. The yield on a commercial property is calculated by dividing the net annual income of the property in the year of purchase by the purchase price. The net annual income is established by deducting all the annual running expenses of the property — rates, insurance, management fees, and so on — from the gross annual income that the property achieves through rentals, advertising, parking, etc.

The key is to identify commercial properties where the tenants are paying below market rentals. If you are able to purchase the property and increase the net annual income the value of the commercial property rises. For example if you purchase a commercial property for R5 000 000 with a net annual income of R500 000 then you have purchased the property at a yield of 10%. If you are able to retenant the property and increase the net annual income to R600 000 the building is worth R6 000 000 if you sell it for the same 10% yield that you purchased it at (to calculate the purchase price you divide the net annual income by the yield i.e. R600 000/.10 equals R6 000 000. If you sold the same property at a 9% yield it would sell for R6 666 000 and at an 8% yield it would sell for R7 500 000. This is a brief but powerful demonstration of how one can make large short term capital gains through buying and selling commercial properties.

Once you have made short-term profits from capital deals in a rising property market, the next critical decision is where to invest the money. As a property player, the most logical investment decision for me is to stick with what I know and invest my profits from capital property deals into income property deals. Income deals are property deals you enter into with the objective of receiving and building both your income stream and the capital value of the property over the medium to long term. Market conditions permitting you can continue to aggressively reduce your bond exposure and operating expenses on these properties by doing capital deals.

Examples of Income deals

1. Residential Income Deals

We have all heard the saying, “Sell when everyone is buying and buy when everyone is selling.” Unfortunately very few investors follow this basic rule of thumb.

In rising market conditions everyone is buying, and this is the time for investors to buy and sell as many properties as they can or alternatively simply sell the stock they have. However, the problem with most investors is that, in a rising market, they buy and then buy some more and buy some more, paying premium prices all the time for properties that they are hoping to let out. As everyone else is also buying, tenants are few and thus rental demand and rental values are low. The problem with this approach is that if you buy properties at a premium price and rent them out at a not-so-premium rental it is not hard to predict a financial nightmare. If you pay premium prices, you are in effect slowing down your growth strategy, as you are buying fewer properties for more money.

In slow market conditions the converse is true. With everyone suddenly trying to sell, you can buy properties from desperate sellers at well below their true market value. This means that you are speeding up your growth strategy, as you are able to buy more properties for less money. As everyone is selling, tenants are plentiful, resulting in strong demand for rental properties and hence higher rental values. If you buy properties for a not-so-premium price and rent them out at a premium rental, the potential financial benefits are clear.

Based on the above information, my advice is to wait for slow market conditions before you embark on buying income deals and building your income-producing portfolio.

When you do your numbers on income deals the key is to make sure that you will never be in a position where you are forced to sell because your holding cost on the property far outweighs your income from the property or other income that you receive. Capital growth will come over time, as will positive cash flow, but you need to position yourself to get through the initial difficult stages.

In a perfect scenario you would be able to invest enough cash made from your capital deals into income deals, so that the property is cash-flow positive from the date of transfer or as soon as possible thereafter. The cash injection must factor in certain allowances, at which we will look now. If you are not able to make a cash injection, you need to factor at least the following into your cash flow and numbers.

• You need to have access to enough funds to cover transfer and bond registration costs in the event that the bank will not finance these costs.
• You need to consider the possibility of at least a 2 to 5 per cent interest rate hike in the first five years of owning the property. Interest rates in South Africa are volatile and prone to rapid upward swings when you least expect it. If rates go down, this is a bonus. If they go up, you need to be prepared to weather the storm.
• You need to understand and calculate the cost of holding the property over and above the monthly bond repayments. This requires a close look at issues such as maintenance, levies, special levies, rates and taxes and management fees.
• You should be aware of the possibility of vacancies for at least two months a year. Your cash flow must be able to cope if it takes two months to find a tenant or to replace a tenant.
• Work out the potential yield (divide net annual income by the purchase price). The higher the yield the better the investment return on the income property and smaller the gap between rent received and potential shortfall on bond repayments.
• On a more exciting note, you can also run numbers that project when the property will become cash-flow positive and what the property may be worth in 5, 10, 15 and 20 years’ time, based on conservative capital-growth projections. However, for the purposes of upfront due diligence, your numbers need to focus on mitigating the short-term risk in holding the property over and above the potential long-term gains.

2. Commercial Income Deals

In my experience, commercial properties offer a number of advantages over residential properties. In this section, you will explore these advantages.

Commercial properties primarily comprise:

• offices, high-rise or otherwise, where you work or which you drive past on your way to work every morning
• retail, consisting of shopping malls and smaller retail convenience centres
• industrial, consisting of factories and warehouses that you see in established industrial nodes throughout South Africa.

Besides commercial properties serving the primary uses listed here, they can also comprise storage parks, graveyards, recreational facilities, gyms, parking garages and many other uses that are commercial rather than residential in nature.

The advantages of commercial- over residential properties

So what are the advantages of commercial income deals over residential income deals?

Tenanted commercial properties can often be purchased for less than their replacement value: Commercial properties are valued on their income stream or potential income stream and not the bricks and mortar that go into creating the income stream. The effect of this valuation technique is that commercial properties that are achieving below market-related rentals can often be bought for well below the replacement value or true market value of the property.

Residential properties, by contrast, are seldom valued on their income stream but rather on the bricks and mortar. The effect of this is that even if a tenant is paying a low rental this will not dramatically affect the selling price of the property and will not necessarily translate into an opportunity to buy at below market price.

Commercial tenants are generally companies and close corporations as opposed to individuals: This means that the tenant is subject to certain transparency requirements and reporting obligations as set out in legislation. This gives you, as the landlord, the opportunity to thoroughly investigate the entity that will be paying you rent. This investigation involves perusing the tenant’s incorporation documentation, schedule of directors, management accounts and audited financial statements, tax and VAT returns. Over and above your investigations, the financing bank will also be perusing the necessary documentation to test the financial fitness and bona fides of your potential tenant.

By contrast, although rental agents are able to do some investigative work on the financial fitness of residential tenants, their information is never as detailed as the research that you and the bank can do on commercial tenants. The bank will also not be researching your residential tenant on your behalf.

The more prestigious and well known your tenant for a commercial property, the higher the price at which the property can be sold for after the lease is secured: This means that a property with an unknown brand soft drink company as its tenant may sell at a cap rate of 10%, whereas the very same property with a major brand name as its tenant could sell at a cap rate of 8%. In the residential property arena, if a property is tenanted by the CEO of a company over a junior accounts clerk, this will not upwardly affect the selling price of a property.

In most cases commercial tenants take better care of your property than residential tenants because they need to impress their clients.Also, commercial tenants are far more willing to make capital improvements to your property in the form of tenant installations that will become the property of the landlord at the end of the lease unless the landlord advises otherwise. This may involve installing air conditioners, blinds, new tiles or carpets, an alarm system and many other improvements that the commercial tenant deems necessary. In some situations the landlord may agree to share the cost of these improvements but in such cases the money spent is usually capitalised into the rental received and more than recovered on the eventual sale of the property.

It is much easier and quicker to evict commercial tenants than residential tenants that breach their lease agreements: In fact, in common law you have a lien over their equipment and furniture, which means that you can sell these items to offset costs. Commercial equipment and furniture can have real value and it is difficult for established commercial tenants to up and go in the middle of the night without being noticed, unlike residential tenants. The norm is also for commercial tenants to put down a two- to three-month deposit, whereas residential tenants usually put down only one month’s deposit.

The provisions of the Consumer Protection Act are also not applicable to juristic persons with a yearly turnover of more than R2 000 000 so commercial landlords with large scale tenants will not be effected by the protective mechanisms for tenants as provided for in the Act.

The most important advantage of commercial income properties over residential income properties is the ability to secure and grow the income stream over medium- to long-term periods: While the cap rates on residential income deals are typically between 3 and 8 per cent, the cap rates on commercial property deals are typically between 8 and 12 per cent, resulting in much higher returns on investment. Commercial tenants also typically sign lease agreements for between 3 and 10 years, as opposed to residential tenants, who usually sign leases that are 6 to 12 months long. The longer the lease, the less chance you have of the property standing empty while you try and procure new tenants.

The real jewel in the crown of commercial leases over residential leases is that commercial leases are usually subject to standard rental escalations of 8 to 10 per cent per annum. This means that if your tenant signs a five-year lease with a 10 per cent escalation the rental payable will increase by 10 per cent each year until the lease expires. Over and above the rental escalation, most commercial leases give the tenant an option to renew the lease at the end of the initial period. However, the terms of the option to renew usually provide for an upward-only rent review. This means that the tenant will renew the lease at a monthly rental amount that is higher than the highest monthly rental paid during the initial period of the lease.

The result of long leases with guaranteed rental escalations and upward-only rent reviews is that the longer you hold the commercial property, not only does it become a cash-generating machine but the underlying value also becomes higher and higher.

Besides rental income, commercial properties also offer additional ways over residential properties to increase the income from the property. For example, if your commercial property has good visibility you may be able to obtain signage rights from council and rent the signage space to advertising agencies. On larger commercial deals in the retail sector, landlords also often insert what is known as a turnover clause into the lease. The effect of this clause is that over and above the annual rent payable, the tenant is also required to pay the landlord a percentage of the turnover achieved. As is evident from the discussion of cap rates earlier, every time you add to or increase the income from a commercial property this translates into more capital value on the sale of the property.

The main drawback of commercial properties for investors compared to residential income deals is that they are harder to finance, as the banks will only loan you 60 to 80 per cent of the purchase price. It is also difficult to procure commercial finance for loan periods longer than 12 years. On the upside, banks are far more creative in financing the acquisition of commercial properties and may offer you interest-only periods and facilities to capitalise the interest for an agreed period to assist with cash flow. If you are able to increase your income stream or secure stronger tenants on watertight lease agreements, the banks are also prepared to refinance the deal a number of times during its potential lifespan.

For a detailed read on this approach please see chapter 5 of “Fast Forward your Retirement through Property” by Jason Lee [Zebra Press 2009] or visit www.jasonlee.co.za.