EPISODE 3: The Numbers - Property Inc

[ Podcast Transcription ]

This is the Commercial Property Investing Explained Series, a free 10 part course brought to you by Steve Polisi. Find out how commercial property really works and start investing like the pros. Your education starts now.

Welcome to the Commercial Property Investing Explained Series with Steve Polisi. I’m Andrew Bean and I’m here with author of Commercial Property Investing Explained Simply and founder of Buyers Agents Polisi Property, Steve Polisi. How are you mate? I’m really good mate, how about you? Fantastic, buddy.

Yeah, I’m looking forward to this episode. Actually, we had a huge response from the first two episodes already. Yeah, it was amazing. Really, really exciting and I’m really pumped rolling out the rest of it. So it should be excellent. All right, mate. So today is going to be seriously action packed and informative episode as we do a deep dive into the numbers behind commercial property.

This is episode three, and we’re going to summarize. Purchasing costs, yields, leases, outgoings, depreciation, capitalization rate and property value and cash flow. So we’ve got a lot to go through. So let’s jump straight into it. So mate, why do the numbers matter so much in commercial property? The whole reason we invest is about the dollars and the cents.

So that’s why the numbers matter. We invest to make money and we’re looking to build wealth through capital and cash flow. Learning about how commercial property really works has never been easier. with so many great resources around like this podcast and Steve’s book and he’s giving it away for free if you use discount code PODCAST on his website.

So go to www. policeyproperty.

com use discount code PODCAST To get the book free, all you have to pay for is shipping. What a great deal. Let’s jump into the acquisition costs or the purchasing costs of a commercial property. So the first one that most people feel the hit from is stamp duty. So for those who don’t know, stamp duty is just a government tax on certain transactions.

It’s applied to like motor vehicles, insurance policies, and of course real estate. It’s normally the big ticket one. So you’re looking at around 3. 5%, it will change state to state slightly depending on the purchase price, but it is quite a big chunk of money to put into a deal. So each state will have a different kind of rule.

Some are sliding scales and some are tiered, and then it’s going to effectively be on the purchase price that you’re paying and it goes from there. Some states, for instance, such as ACT and South Australia don’t actually have stamp duty on commercial purchases. Yeah, it’s awesome. So mate, what about things like GST?

When does that become applicable like in commercial property? So this one always gets talked about quite a lot about GST. You only pay GST on a commercial purchase if it’s a vacant property, but if you are buying it with the intent of it being an investment property, you’ll actually get that GST back on your first BAS statement or tax claim.

When it does have a tenant, it’s considered what’s called a going concern. So you don’t actually pay the GST on the purchase price. And so there are a few different like, uh, little ways you can kind of get around that on there, Steve, as well. Do you want to share those? Yeah. So one of the ones we commonly do with our clients and basically the seller is you can get them to give you basically a rental guarantee.

So it’s effectively like a lease, so you’re getting a lease off the owner and then you don’t have to worry about the GST on the purchase from that front. So what are the other costs we might come across when we’re purchasing a commercial property, Steve? So similar to residential, you’re going to have your legal and conveyancing fees.

If the property is part of a body corporate, you’re going to have the body corporate inspection report. You’re going to have to pay for a building pest inspection and then sometimes the cost of a survey. One of the differences with commercial is actually you have to pay for a valuation with the lender.

So where residential, the bank basically looks after that for you. You will have to pay that with a commercial property and it’s quite significant. Most of the time it’s 800 to 2, 000 for a smaller size commercial property. And mate, with the legal fees and stuff, does that actually change or is that fixed?

Like, does it work with how big the property is, or how does it work? Not so much how big it is, it’s normally how complicated the deal is. Obviously solicitors will have their own kind of fee structures and they’ll try to get a bit more money out of you for commercial because it is a bit more complicated, but it’ll normally just depend on the complicity of the deal.

So if you’ve got like five tenants, that’s obviously going to be a lot more work than a single tenant warehouse, for instance. And with the valuation, is that kind of the same thing? Yep, basically the same thing. Every lender is going to have a different fee. I’ve seen kind of valuations 5, 10 grand for the bigger kind of shopping centers and things like that.

But the standard kind of warehouse or retail kind of property that most mom and dad clients are going to buy, you’re talking around that 800 to 1, 200. Yeah, fair enough. And I actually came across this recently. For a self storage facility because the amount of due diligence and research and market research they have to do for evaluation for a self storage facility is huge.

So the amount of money it costs to do evaluation is significantly more than if you’re just doing a kind of standard warehouse. Yeah, it’s because it’s a specialized asset, like same as if you’re buying a petrol station, for instance, you’ll, you’ll be hit with a bigger fee. Yeah, definitely. So, mate, to sum it all up, is there like a rule of thumb, like a percentage rule of thumb that you would use like in your preliminary calculation to determine like the acquisition costs?

Yeah, so the back of the envelope number I use is just 5%, so that normally covers the 3. 3 to 3. 5 percent stamp duty, and then the other costs we just mentioned then, so. I always encourage though, make sure you check all these numbers if you are seriously looking at a property though. It’s just a back of the envelope check.

Yeah. So like, this is like just a 5 percent rule, like you’re literally doing on the back of a napkin or on your calculator on your phone. But when you’re actually drilling down into a deal, you actually want to be getting a hard figure for this and actually calculating it properly, don’t you? Yeah. A lot of the times I’d mainly just use it if you’re trying to work out your budget.

So if you’ve got a 30 percent deposit, you’re actually going to need a 35 percent deposit for a 70 percent loan. Yeah. Yep. That’s right. All right, mate. So let’s move on to the next topic, which is yields. So yields is always spoken about. And a lot of the time, residential yields are always compared with commercial yields, but they’re not the same.

So a residential yield is a gross yield. And the reason it’s a gross yield is the tenant doesn’t pay the outgoings like they do with the commercial. The owner has to pay the council rates, the water rates, the maintenance, the insurance and things like that. Whereas with commercial, the actual rent you receive, the tenant will pay those costs on top.

So, commercial yields are net yields, whereas residential are gross yields. So, most of the time you’ll find the return is three to four times as great on a commercial as it is a residential. Yeah, and the term yield does get thrown around pretty loosely. In Australia by agents and invested, it’s almost like they use it interchangeably with cap rate, basically use a cap rate to compare properties that are alike.

Whereas the yield is just a generic way to compare all investments. Yeah. I mean, the way that I like to actually refer to yield. Is the yield is the actual return on the property and it has nothing to do with say like market conditions when you’re buying and selling. So like for example, if you own a property and you bought it 10 years ago, the yield for you, like say it was like a 10 cap when you bought it, the yield for you today would still be a 10 cap or greater.

But if then, if you went to put it on the market, you’d actually be advertising that at say like a six cap, because now the market has changed. So yield is actually actual return on the investment to you yourself. Whereas a cap rate is specific to the market conditions at the time. Shouldn’t be interchangeably used, but unfortunately, the way that we seem to do it, we do actually do it like that, so.

Yeah, and you, you got to remember as well, it’s, the actual number isn’t actually that useful because most people are leveraging with commercial property anyway. They’ve got a 70 or 80 percent loan on it, so your return on investment or your cash on cash is actually different. That’s right. All right. So let’s move on to the next topic, mate, which is one of the most important aspects of commercial property.

And that’s the lease. We’re going to go into detail in a later podcast episode about the ins and outs of a lease, but let’s just go through the numbers here, Steve. Yeah, so leases and this is the strength of commercial properties. You actually get long leases. You can get three year, four year, five year, even 10 year leases in some instances.

So much different to residential where you’re getting a 12 month or 24 month maximum type of lease. There’s also a few types of leases. You’ve got the gross lease, net lease, triple net lease, and absolute net lease and things like that. But in terms of the numbers, the main ones you’re going to be looking at things like the bond and the guarantor details of how much money or collateral is sitting there to protect you, start and end dates of leases, length of the lease, options on the lease, how much the rent is, details about the rent increases and reviews, details of the outgoings, who’s responsible for repairs and maintenance.

Any additional factors such as fit outs, rent free periods and insurances and things like that. So all of those are going to have corresponding numbers that you need to check and part of due diligence, you need to cross check them very carefully. And so Matt, like how much weight would you put on a tenant having an option, say the option period was like another five years.

How much weight would you put on having either getting a tenant with an option or a tenant without an option? For me, it doesn’t matter so much because I always interview the tenants to find out what their intent is. So whether they’re at the end or a new lease, getting a new lease can actually pay dividends.

Anyway, the options actually aren’t to protect the owner. It’s actually to protect the tenant because they don’t want to be able to kick out of their property. They want long term kind of security. So it’s not as important. You need to be having that long term mindset. And what about the actual lease period?

That’s a pretty important number. What kind of number are you looking at a lease period? It’s going to depend on what you’re buying. If you’re buying a little 200 green warehouse, for instance, it’s very unlikely that you’re going to get a five year lease because it’s going to be a small time business that’s probably just going to sign a 12 or 24 month lease.

However, the benefit of those is vacancy rates on the small warehouses, for instance, are really short. So even though you might go through a new tenant every five, six, seven years, the vacancy period is only one to three months. Whereas if you say go out and buy a 3 million warehouse, you actually will get the longer leases because they’re large businesses that need to be there longer time.

They’ll be there five, six, 10, 15, 20 years. However, if they leave, you generally got a longer period of vacancy. Cause there’s not a thousand big businesses ready to jump on that property. So you might be looking at six to 24 months worth of vacancy. So to answer your question about what length you’re looking at, it’s just going to depend on what the asset class you’re buying.

Sometimes coming towards the end of the lease actually gives you opportunities because if it’s below market rent it’s an excuse to push up the rent to market rate and fabricate some capital growth. And this is also a number that the banks look at though, isn’t it Steve? Like the length of the lease.

Can you just kind of explain to us how the bank will set your loan up depending on how long the lease is, depending on their appetite for that type of asset? Yeah, so a long lease is always going to be looked highly upon by the banks because it’s going to give you some form of security. It is going to depend what type of loan you’re getting.

If you’re getting like a full documentation loan, then it’s less important than say like a lease loan. If you’re getting a lease stock loan, you need a long lease because that’s how long you’re getting the loan period for. So it’s always nice to have a really long lease, but chances are if you’re buying a property, it’s rarely going to be a fresh lease.

So you just need to weigh up what’s actually better. Like one of the examples I always use is, is buying say a 5. 5 percent net yielding warehouse. That has 18 months left on the lease better than buying a 5. 2 percent net yielding warehouse that has three years left on the lease. And there’s no right answer because I’d personally buy the one with the shorter lease because part of the tenant interview if they say they’re going to sign the next lease.

I’m actually going to get longer than I’m going to get the year and a half plus the fresh five years and I’m going to get a better net yield. So it’s just balancing what you’re buying and versus your risk profile. So just to summarize, when you’re looking at commercial property, the lending that you’ll be able to get the amount of years to actually have a lend on that will be dictated by the length of the lease.

In some cases. All right, mate. Now that actually dovetails nicely into the next topic that we’re going to talk about because this is another one that the banks really do look at and that’s the whale. What can you explain what whale means? So whale is weighted average lease expiry. So it’s basically the length on the lease.

However, it’s used when you’ve got multiple tenancies. So if you say you’ve got like a, you’re buying a little retail shop and you’ve got five little shops in the retail center. Each of those tenants are going to have different lease terms. So they’re going to have one might be on a two year lease, one might be on a five year lease.

You might have an anchor tenant like an IGA or a Woolworths or whatever it may be. So it’s a way of working out what the average is for that property. You can also do it to your portfolio. So if you’re an investor that has lots of commercial properties, you can actually look at the whale for your entire portfolio and give you a sense of surety of like, okay, how risky is this portfolio?

Lenders always going to look favorably on a high whale, same as they’re going to look favorably on a high lease term. So it is, it is quite important for the multi tenancies. So mate, how do you actually calculate the whale and what are the two different types of whales? So the two types of whales are area whale and rent whale.

So for the area whale, for instance, it’s calculated by multiplying each of the tenants area percentage by the remaining lease on their tenancy and then adding both of those figures together. So for instance, if tenant one is a supermarket and it’s got a 50 percent of the leadable area and five years remaining on the lease, you’d multiply those two numbers together and you’d get effective lease of 2.

  1. And then you do the same thing for the other tenant and then you combine them together. So area whale is good for a lot of times if they’re looking at valuations and you’re looking at square metre rates. It’s quite important there. Whereas the rental whale is actually the better, stronger one for yields.

The rental whale is the one that’s usually used by banks and also agents as well. Yeah, I’ll always compare the both of them though, because it’ll give you an idea of kind of, is it fair rent over the whole complex and who’s paying high rent, low rent, things like that. And so, do you calculate the rental whale differently to the area whale and how do we do that?

Same concept. So you multiply each of the tenants percentage of their rent of the total complex by the remaining lease term that they have. So it’s got to do with actual rent they’re paying and the percentage of rent. As opposed to, say, the area, percentage of area that we mentioned before in the area whale.

And so when you look at it like you’re getting 100, 000 and one person is paying 60, 000 and the other person is paying 40, 000, and how many years they have left, the rental whale is weighted towards one tenant? Yep, exactly right. So if you had like a, A Woolworths shopping center and then next to it is just two little shops.

There’s one’s like a cafe and other ones, uh, a barbershop. The rental whale on the actual Woolworths is going to be the defining factor. So that’s the important lease term. Cause that’s where the bulk of the money is coming from. I hope you’re enjoying the show. We’ll be right back after this short break.

Stay up to date with all the hints, tips and tricks in commercial property by following Policy Property on Facebook. Go to Policy Property, hit that follow button and never miss a beat with Policy Property. All right, mate, let’s move on to outgoings. It’s also a very, very important number and something that gets thrown around in commercial property a little bit.

What are the outgoings and who is responsible for paying them? All right, so similarly we mentioned before with residential, commercial is net. So the tenant normally pays the outgoings. Some of the outgoings that we’re normally going to pay, so council rates, your land tax, property management fees, water and utility rates.

Body, corporate fees, insurance fees, maintenance costs. There’s even one that’s like if you’re buying in a complex, gardens and landscaping, cleaning, rubbish removal, fire inspections, backflow prevention testing. So there, there’s quite a lot of outgoings that need to be paid. Most are paid by the actual tenant.

However, the ones that typically aren’t are property management and land tax. But even then, land tax is sometimes covered if the property itself is over the land tax threshold, the tenant, it’ll be concluded as part of the outgoings and they’ll pay that for you. I think we need to specify that is that the outgoings can be paid by the tenant, depending on what the lease says.

Yeah. Exactly right. So mate, with the property management fee, this is one that always seems to get left out by agents. Do you calculate it into your numbers when you’re doing your final cash flow? Yeah, I always do. And sometimes you actually don’t know who they’re paying. So even if it’s in the lease, for instance, the lease is just a rule book between you and the tenant.

So even though it’s a legally binding contract, stuff goes on under the table, there’s handshake agreements and things like that, but they’ll normally leave it out because you don’t have to have a property manager, like a lot of people self manage. So, you only have to include it in your cash flow if you’re actually going to use it.

Yeah, so like a good rule of thumb is, if you’re going to be looking at a deal and the agent gives you the I. M., the information memorandum, you have all of the outgoings, and you are actually going to be using a property manager, then factor in like five or six percent of the gross income, and that’s what you’ll be paying your property manager.

So it really does make a difference, putting that in, or, and how you’re valuing the property once that outgoing is in there. Yeah, exactly. It’ll also depend on the size of the commercial that you’re getting, because if you’re buying a 5 million warehouse, that the management fee won’t actually be 5%, it’ll probably be 3 to 4%.

If you’re buying a little 200, 300 grand warehouse, you’re probably up at 8%. So it’s normally a bit of a sliding scale. Most, most property managers want to make sure they at least get a few grand. So three to six grand in their pocket. Again, if it’s multi tenancy, you need to take that into account. The re letting fees is actually a big one that most people forget as well.

You offer incentives. Then they also charge another percentage for a new lease, for instance. So a property manager might take 15 percent of the first year’s rent. As a letting fee. So take into account all those additional costs because they do add up if you’ve got a volatile tenant. Yeah, that’s right.

So mate, you mentioned insurance fees, like a lot of the times you might actually get that figure, you might even get premium statement of what the insurance is on the property that the current tenant is paying. Would you tend to actually go out to an insurance broker and find the actual figure that you’ll be paying, and then to make sure that.

The property is that the right kind of level. Yeah. So I always speak with an insurance broker and cross check every single insurance figure. It’s the only thing that really protects you if it goes badly. So you’ve got obviously your building insurance, your landlord insurance, you need to ensure that your tenants got public liability insurance.

And I always like to take as much control as I can of all these things because. You actually don’t know if you don’t have control of it and the tenant and was responsible for the building insurance or public liability And they just stop and don’t tell you and then something goes wrong. You’re responsible for it So I always want to make sure that i’m actually checked in and that’s why a good insurance broker actually really comes into play A lot of people will just go online and try to book and find their own insurance But I always speak to professionals now in this industry because that’s the only form of protection you’re going to have Yeah, and like with these properties, if the owner’s owned it for quite a long time and they’ve taken out that policy years ago, and obviously the policy’s increased each year, like dollar wise, but they might not have the sufficient amount of cover for what you want for the risk level that you want to actually take.

So it’s always prudent to actually check that yourself and make sure that you’re 100 percent covered because like Steve said, at the end of the day, you’re the one that’s going to be on the hook if something goes wrong. Yeah, exactly. It’s, it’s worth mentioning as well, like I’ve used the term insurance broker.

A lot of listeners actually know what that actually is. So like, an insurance broker is effectively like a mortgage broker, but they live in the insurance world. So they’re the ones that go out and go to all the different insurance companies. And then assess what they’re offering, how much the premiums are, and then present you the best options moving forward.

So it just saves you trying to do it online yourself and with commercial, because it is more complicated, going to be very hard for you getting known more than them. And like a mortgage broker, they don’t actually charge you anyway. So they normally get you a better rate and they do the work for you. So I highly recommend using an insurance broker.

Yeah, it just makes sense. I mean, why wouldn’t you? It takes away, you know, your stupidity of getting the wrong policy. I would never ever go after a property without using a mortgage broker or an insurance broker. So the other cost that you mentioned was maintenance costs. Now this is an interesting one because there are a few different ways of looking at this.

Do you have a rule of thumb that you like to use, like a percentage of the value or percentage of the rent or something like that? No, not really, because it is going to come down specifically the type of property that you’re buying. So if you’re buying a retail shop front, that’s part of a body corporate, there’s very little maintenance costs for you because the body corporate is going to have their admin and sinking fund.

And then the tenant is going to be responsible for most of the maintenance because they want to clean shop front, for instance. So they’re going to be in charge of the glass, the internal maintenance, things like that. If you own a whole building, for instance, law, a freestanding building. And then you’ll need to take into account kind of maintenance costs because if the roof falls in, you’re going to be responsible for instance, similar to residential though, it’s going to depend on what you’re buying, the age of it, how sturdy you think it is, when you’re going to need renovations.

So you need to do this one on a case by case basis. Yeah, fair enough. So mate, what about fire protection? Is this a case by case basis as well? You want to check it on every single deal. So if it’s part of a body corporate, ensure that the body corporate has an inspection details for that. If you own the building freestanding, ensure your property manager is also doing the fire inspections, because again, it’s about covering you and liability.

Alright mate, so I think we’ve spoken about outgoings and detailed that enough. Obviously, they’re very, very important to double check all of the figures that you’re given. And that’s why you have a due diligence period as well. You accept what they’re saying to you. but you reserve the right to check. So mate, let’s move on to our next topic, which is depreciation.

We spoke about depreciation in a previous episode, but can you just talk us through the numbers of how it works here? So depreciation is the loss in a property’s value over time, basically due to wear and tear and aging of the property. One of the other benefits with commercial over residential is you actually get higher depreciation.

And the main cause of that is because the building construction costs are more. So having large concrete panels, for instance, is more expensive than a timber frame. So you’ll get larger depreciation benefits with commercial. You can also claim more. So where, for say, residential property, you can’t claim things like plant and equipment, which is basically anything that you can basically bolt on or remove, like air conditioners and things like that.

You can still claim them on commercial, so. Your commercial guidebook, there’s like literally tens and tens of pages of things you can claim, so you will get a larger depreciation report effectively moving forward with commercial. Yeah, and as we mentioned on a previous episode, once you buy any kind of commercial property, you can immediately reap the rewards of depreciation, putting a depreciation schedule in place.

But in residential, it’s not the same. If you haven’t bought that or you haven’t developed that new, brand new, then you can’t always depreciate it, each item on there. So who can help us getting a depreciation schedule? All right, so a depreciation schedule is also called a tax depreciation or TDS. So whenever you see the words TDS, they’re talking about the depreciation schedule.

Basically, you go to an expert called a quantity surveyor, and then they’ll write you a report telling you exactly what you can and can’t claim, and then you give that to your accountant, and then on the next tax return, you’ll reap the benefits of it. And this is almost like a paper loss, isn’t it? Yeah, exactly right.

I’m always weary when I tell people like it’s just a paper loss because you are losing value of your property in 20 years time, the building isn’t worth the same as it was now. So, even though you’re getting money for it and it feels great now because it’s great for your cash flow and you can use that money for another property, you still need to be weary of that you’re losing the money long term and at some point you’re going to have to put some money back into it for renovations, for instance.

So the good thing is the money you spend on renovations, you then get to claim that back on tax as well. It’s a nice little cycle there. So mate, how do we actually calculate depreciation? So the quantity surveyor will basically go through the property and inspect it and look at all the construction costs and things like that.

So the first one is they look at capital works. So that just refers to like the building structure and anything that’s permanently fixed. So that can be like the actual frame, alterations, improvements to the building, structural improvements, even earthworks such as embankments, they can include. And then the other one is one I alluded to before is the plant and equipment.

So that’s basically anything that’s removable. So that can be like air conditioners, fridges. ovens, if you’re an industrial property fans and things like that. So they’ll go through both of those, the plant and equipment and the capital costs, and then give you a different methods of actually how you can claim that back on tax.

All right. So you mentioned methods there. What are the different methods they use to calculate depreciation? All right. So on the report, you’re going to get basically like two columns. One’s going to be the diminishing value method. And that basically gives you a high claim at the start and smaller claims later on.

This is the one most investors choose because it’s more money in your pocket now. And the reason for that is it’s similar to like buying a brand new car, a brand new car depreciates quite a lot at the start for the first five years, and then not so much after that. However, the other way you can do it is called the prime cost method.

It’s also known as the straight line depreciation. That’s just averaging out the depreciation year on year. So you actually get the same back every year. That’s a good method if you want a stable kind of cash flow and you want to know what your return is going to be each year. And so when do you get to actually make this choice, Steve?

Basically a tax time. So once you give the depreciation report to your accountant, you can tell him which method they’re going to do. Like I said, most people do the diminishing value method because they want the high tax back now and then they can use that to put into future properties. But again, if you’re a high net worth client, sometimes you actually want to spread it because you might be selling a business or getting a big influx of costs or sold a property recently, you’re going to be slapped with big capital gains taxes.

So it’s just going to be case by case, depending on your circumstances. So mate, like with a depreciation schedule, it’s, it can be a little bit confusing for people who don’t. Understand it. How many of these do you actually need to get raised? Do you have to do it year on year or do you just do it once?

Just the once. So basically as soon as the property settles, I recommend going to get a depreciation schedule and then you can get to use that for the life of the property. If you do any renovations or anything significant from then on, you’d get an update to the depreciation report. So just the once.

And they’re reasonably cheap as well. They’re normally between 600 And you’d make that back more so on the first tax return anyway. Yeah, that’s right. All right. So we’ve covered a lot of topics here today already, but we haven’t touched on how we actually value commercial property using a cap rate. So mate, what is a cap rate and how do we use it?

So cap rate is capitalization rate. And we mentioned before, it’s just, it’s just a concept used to compare that property at that moment in time with other properties and different classes of properties will have different cap rates. Like you can’t compare a cap rate of a office space with an industrial.

And then even in the individual properties, you can’t compare a small warehouse with a large warehouse, for instance, you need to just a back of the envelope way of comparing like for like properties. A cap rate is different per sector and per market. So you could have a market say like in a capital city where a cap rate for a specific type of asset, say industrial, is going to be wildly different to a cap rate, say in somewhere like Toowoomba.

It totally changes to where you actually are geographically and investors risk appetite for that kind of asset in that kind of location. Yeah, exactly. Right. And then if you’ve got something like specialized, like medical, a medical retail is going to have a completely different cap rate to a hairdresser, for instance, because it’s got a much larger fit out cost.

Yeah. I mean, cap rate is probably one of the. The one things in commercial property that is a little bit speculative and also a little bit of your perception of it as well. Yeah. And it changes over time anyway. So you can do the same as residential property and you can actually just look at a comparable sales at the time.

Should you want to get it? You don’t have to be using cap rate and net yields and things like that. You can just use the old traditional method of comparing other properties like for like. Yeah, it’s just a lot harder to sometimes find comparable properties with comparable tenants on comparable leases.

So I guess that’s why we use a cap rate. That where I was kind of getting at, just for instance, if I didn’t like medical, I thought medical wasn’t reliable and I didn’t like it. I might only want to pay a six cap, but Steve really likes medical and he knows that it’s really risk averse and it’s a good asset.

with a great tenant that’s sticky, he might be willing to pay a five cap. So that’s where I’m kind of trying to explain that it does have a little bit of your personal preference to what you think you should be paying for that. And then also what the agent’s personal preference thinks that what should sell at when they’re listing the property as well.

Yeah, it’s a nice way to talk to agents and sellers, for instance, just so you can you can have some form of like for like comparison. So it is just a high level way of comparing properties. So mate, can we just give us a bit of an example on how we should actually calculate the value using a cap rate?

Alright, so let’s use the example of a 7 percent cap rate in the area and the net rent is say 70, 000. Then it’s basically 70, 000 divided by 7%. So that’ll give you a million dollars. So your purchase price, you should be looking for that property is a million. And you can do that in reverse. Obviously, if you do a million dollars and you’ve got net rent of 70, 000, 70, 000 over a million dollars, it should give you that 7 percent cap rate.

And I’ve actually got another way of understanding this as well, Steve. And it’s, I can’t remember anyone ever speaking about cap rates like this. The way that you could look at a cap rate as well is that it’s actually a multiplier. Let me try and explain this. So a cap rate reflects the actual perceived risk of a market and the willingness of all of the investors as a group to pay that percentage of return for that market, right?

So, if you’re looking at it like it’s an actual multiplier, Say we have a 100, 000 net income, and you had a one cap, right? So that’s 100, 000 divided by 0. 01, that would be 10, 000, 000. But that actually equates to 100, 000 times by 100, which is also 10, 000, 000. Does that make sense, Steve? That’s not how my brain works, but if it works for you, Andrew, go ahead.

It’s actually quite interesting and you can do it on a sliding scale and I’ve actually figured this out. So if you actually got a two cap that works out to be a 50 times multiplier. So if you had 100, 000 net income and you times that by 50, that would be 5, 000, 000. Same equation, if it’s a 2 cap, it’s 100, 000 net income divided by 0.

02 is 5, 000, 000. So it’s hard to conceptualize the multiplier method because we have to try and understand what type of return we get. And it’s actually similar to how they Value businesses using an EBITDA. So that means earnings before interest taxes, depreciation, and amortization. But I guess, because we have to be able to conceptualize this to how much return we’re actually getting per property, it’s a lot easier to actually understand that using a cap rate.

So if you wanted to actually do more like of a sliding scale of where you would be at, so a four cap is actually a 25 times multiplier. And a 5 cap is actually a 20 times multiplier, and it goes up from there. But it’s actually another interesting way of looking at it, if your mind works like that in a multiplier kind of way.

But I haven’t heard anyone talk about it like that before, but I thought I’d just throw that in there just to try and help people understand. No, it’s just everyone’s brain, especially with mathematics, works different. And I’ve seen it with clients, I’ll present something one way and they’ll just completely go over their head and then they just express it in a different way.

It’s the same as when you talk percentage, if you’re doing like dividing it by the percentage, some people need to times it by the hundred afterwards because they don’t understand that all the divide by the hundred. I should say that I don’t understand that 7 percent is actually 0. 07. They do it as 7 over a hundred for instance.

So, interesting fact, a 7 cap, uh, 0. 07, is actually a 14. 286 multiplier. So if you had a net income of 100, 000, you get the same calculation as a 7 cap, you would times it by 14. 286, and you’d come up with the same valuation, which would be 1, 428, 571. Yep. One point to note as well as people get confused with cap rates and especially when cap rates are compressing.

So when you have say a 7 percent cap rate compressed to a 5 percent cap rate, they see that as 2 percent change and they kind of in their head think of getting 2 percent capital growth. It’s not, it’s 2% over the 5%. So it’s actually quite a lot. It’s actually 40%. Yeah. And another thing that it’s, some people don’t get their their head around when cap rates go down, the value actually goes up.

Yep, exactly right. , what actually cap is, when cap rates go down, the multiplier goes up. So it’s actually a sliding scale as well. So if you’re looking at it like a 10 cap, right, that’s a 10 times multiplier, which is a million dollars. But then if you go to, uh, for instance, a 20 cap, that’s actually a five times multiplier.

Just to confuse everyone even more. Yeah, it’s very hard on a podcast to grasp when you’re not looking at a page, I think. So mate, how can we actually find out what the cap rate is in a specific area? So this is obviously a lot more difficult than residential where you’ve got a plethora of options to choose from like a three bedroom house, you might have a hundred comparables, commercial are all going to be different.

They’re going to have different lease terms, length of lease, types of tenants, fit out costs, foot traffic, road traffic and things like that. So it is a lot harder to compare. But the first thing I do is go in CoreLogic and then check the sales comparisons of anything that’s sold in the area and see if you can compare any of them.

Another one is actually to ask the selling agent. So a selling agent or a property manager in the area, they’ll know quite well and give you a good gauge of the cap rates of the area because they do it all day, every day. And then the other one is actually looking at advertised properties for sale, because even though they won’t say the price, you’ll get a general gauge.

If you inquire on a few of the properties and they’ll kind of tell you the price they’re willing to sell for, you can start to get a thumbs up figure. And then the other one is actually speaking to valuers. So this is a little trick that most people don’t know about. If you speak to a local valuer, Their job is to literally value properties and they do that off cap rates.

So they’ve got a really good understanding of certain markets. There’s actually one more way of actually checking that you haven’t mentioned there yet. There is, Andrew. There’s a website I use quite regularly called CP Data, owned by yourself, which gives you all this kind of data for medium prices and comparable sales.

But it is always good to check, you know, with a lot of different sources. And so the value is actually a really, really good idea. Sometimes it’s a little bit hard to nail down. A valuer to get them to actually give you details and also Steve did mention about talking to the actual listing agent. Just be aware that a listing agent that’s in the area will always be slightly biased to the area.

So it is good to find or speak to a source that is not kind of biased or has any kind of financial reward from giving you the information. Yeah, one of the tricks is actually don’t speak to the listing agent. You actually speak with another selling agent and basically you can inquire on one of their properties and just mention you look another one.

They’ll be devil’s advocate. They will tell you everything of what’s wrong with that property and why you shouldn’t buy it. So they’ll give you the truth behind the property as well. Yeah, before I actually, we set up the platform CP data, I’d actually list out about 10 or as many agents as I could in that specific area.

And I’d have about five points of questions that I would ask each actual agent. And then I could actually kind of reference or get a range of what the actual cap rate per that asset is. All right, mate. So what are some of the reasons why a cap rate can actually get lower? So basically it’s supply and demand.

So if there’s more buyers in the market and there’s less sellers, people are pricing up, that can happen from a multitude of reasons. So it can be interest rates, inflation, just rental increases, how the economy is doing, confidence in the market, what the residential market’s doing. So there’s a whole plethora of reasons why it can tighten.

The good thing is it actually equates to capital growth. And we’ve seen this basically, what, in the last 12, 24 months, Steve, with interest rates actually were lowering, you know, this is May 2022. So it did make a big difference, the interest rates going lower. Yeah, exactly. Right. So we saw cap rates, like you could quite easily, two years ago, buy a 7 percent cap rate.

Now it’s hard to get a 5, 5. 5 percent in the same area. The funny thing is the cashflow of the property hasn’t changed that much. So where you were paying four and a half percent interest rate on a commercial property and a 7 percent yield. Now that you can get 6 percent interest rates, the actual year on year cash flow is actually different.

The great thing is if you owned for two years ago, you’re really reaping the benefits now because you’ve won on both fronts. Yeah. It’s funny. The magic number that you kind of shoot for keeps on changing. So like three years ago, it was like an eight cap. And then two years ago it was a seven cap. Last year it was a six cap.

You know, who knows where it could go to? Hopefully it doesn’t get too much lower. Yeah. And this is why I always tell people focus on long term when you’re buying a property, look for the next 20 years because that stuff is actually out of your control. But if you buy well and there’s demand there, you’re always going to have some capital growth.

Yeah, that’s right. So mate, what are some of the reasons why a cap rate can actually get higher? That’s when there’s lack of interest in the market effectively. Normally that’s got to do with local area. So if you buy in like a mining town and the mine closes down, that will push cap rates up. Another one, if there’s oversupply, so if they build.

So you’re buying a warehouse and they build 200 new warehouses right next door to you, there might be a push in oversupply, and then the reverse of all those economic factors we just mentioned before. And it’s funny, just to touch on cap rates before per the different area, through like my research for CP data, we’ve done the whole of Australia researching it, I actually kind of came to the realization That a cap rate is actually a perspective or the sentiment of someone about the region as a whole, as in like the population, but when you actually drill down, so say like you’re looking at like a capital city, the cap rate in the capital city, say like Sydney, it could be like four or 5 percent or something like that for it, depending what type of asset or sector it is.

And if you’re looking at the same asset type and sector. In more regional place. It’s obviously going to be higher, but when you actually drill down that region. The supply and demand ratio actually might be in your favor for buying in that region with say like 000 in population, as opposed to the capital city where there’s a lot more people, but there’s also a lot more supply.

But if you actually look down and really go to specifics about the supply of the property and then the actual demand of the actual asset type in that regional location, it can be wildly. In your favor with really low vacancy rates. And you’ll find that across Australia now there’s actually a little bit of a shortage of industrial land and industrial warehouses.

So you’ll find vacancy rates across Australia for industrial properties are really low at the moment. So it really depends on you or your perspective of how you feel about buying into that market. But you might be able to go into a region and get say like a six and a half, maybe a seven cap with a better supply and demand ratio, as opposed to buying in a capital city where it’s perceived to be less risky, but the supply and demand ratio is actually not in your favor.

Yeah, that’s actually a myth. That’s the capital growth myth. One thing, especially Sydney, Melbourne, they think that’s the best performing location of all time. It’s actually not, even with residential, if you go back and compare residential and commercial 30 years ago, Sydney and Melbourne aren’t the top performers.

You’re absolutely right, Steve. The actual best performers were basically all regional locations for residential. Yeah, exactly. But you do need to be mindful when you are buying regional, you have to understand that area quite a lot more. You do get some security with the herd mentality of the Sydney and Melbournes, for instance, where the property does go vacant, you can sell the property down the track, there probably will still be a buyer for it, assuming you bought in a good area.

Whereas the regional ones, especially if you’re going very regional, the selling kind of times are a bit longer. Yeah, that’s right. I mean, you might have a specific numbers that you actually work to. So like you might not want to buy something in a town or a region with less than a hundred thousand people, for instance, like it just really depends on your personal risk profile.

Yeah, and it depends what you’re buying as well, like regional towns, you mentioned like retail, for instance, has lowered vacancy rates compared with most capital cities, because most of the time there’s only one or two main streets that have the retails, whereas in the cities, they’re all over the place.

Now with the working from home culture, people don’t go into shops as well. So again, you just got to assess it on a case by case basis. I can’t stress that enough. Yeah, that’s it, mate. Always do thorough research and definitely be checking all of your sources. Alright, mate, so we’re down to the last topic of today’s episode, which is cash flow, the final number that pops up at the end of your calculation.

Mate, can you define what cash flow is? So, cash flow is the thing everyone loves about commercial property and probably why 99. 9 percent of people buy commercial property. So, cash flow is basically the net income you get, minus the mortgage repayments, minus all the other expenses you need to pay, and that’s what you’re left with at the end of it.

So, for instance, say we buy a million dollar property, and you’ve got a 700 grand loan on it, and a 6 percent net yield, that’s 60, 000 rent. And on an interest rate of say 3%, that’s 21 grand loan interest. You’re left with about 40, 000 passive income from the get go. So I’ll say that again, 40, 000 passive income on a million dollar property.

And that’s, that was one of my mind blowing moments with commercial having a property that gives you a 40 grand passive income when people are going out in Sydney, Melbourne, buying 2 million houses. You could go buy 2 million worth of commercial and have an 80, 000 passive income and actually retire from day dollar.

And I actually tell people this and they don’t believe you. You have to see the numbers. And I’ve actually got a calculator on my website, a cashflow calculator. So if you want to go there, you can download that for free and have a play with the numbers and prove it to yourself. I’ve witnessed the same thing where you try and explain to someone who has obviously no real understanding of commercial property, and you tell them like, you could literally retire from one or two properties.

On the other hand, you could go out and try and buy 10 to 20 residential properties to possibly get the same outcome, but with a million more headaches. They don’t believe you. It is one of those ones where it sounds too good to be true. Yeah. Yeah. But just to premise this. You, you do need to know what you’re doing when you buy these properties, because it can go much worse.

Like with residential, as long as you buy on a good suburb, you’re probably always going to have a tenant. So it might be slightly negatively geared and you can afford that, but if you go out and buy a bad commercial, cause you don’t know what you’re doing and the tenant leaves and you have a really long period of vacancy, that period will be much tougher.

But if you are in that position where you can’t handle the vacancies, just buy a really low risk one, like you said, industrial in some areas, vacancy rates is just as tight as residential. Yeah, that’s right. I knew you do have to know what you’re doing. Not every single commercial property, you know, is actually cashflow positive.

You may come across ones that aren’t, especially if you don’t know what you’re doing and you’re buying it at a huge price and you might actually be paying way more than you’re supposed to. That’s the whole reason for this podcast and why I wrote the book is just to bring awareness to it because once you understand the numbers, it is really, really attractive.

Now let’s go on to another metric that’s also commonly used in commercial property and that’s cash on cash return. Can you explain that to us? So this is the one where we normally get confusion with people, especially people who are fighting shares. So when they say, Oh, by the share market, I can get better than a 6 percent net yield.

I can get a 10%. You need to look at cash on cash and return on investment. So cash on cash is basically the amount of cash flow you get from the property over the amount of cash you put into the deal. So that’s the acquisition cost we’ve mentioned before. So basically your deposit plus your stamp duty, plus any other purchasing costs.

And then you work out that kind of percentage and return on investment is slightly different. That also takes into account the capital growth. So that’s the one where you can actually compare it with other investments and compare it with shares. And again, I’ve got a tool on my website you can download for free.

The cash on cash and the ROI on properties with commercials is way more attractive because you’re using leveraging to your power. So just, just to put it in perspective, a million dollar property on say 3 percent loan interest rate and a 6 percent net yield, you’re looking at a cash on cash return of about 12.

5%. If you get capital growth, then your ROI is actually going to become 27 percent per year. So that’s, that’s very attractive when you start comparing it with the share market. Yeah. And just to summarize that cash on cash return is basically just looking at the cash that you have personally put into that deal as opposed to the cash that you’re getting back out of it.

It doesn’t include bank finance at all. It’s your cash you put in to actually purchase the property and your ROI actually takes into account. All of the actual money involved in the property and then also that sale price at the end, it’s not usually used for a cash flow metric. It’d be more used in like a development, selling the property or disposing of a property.

Yeah, exactly right. And comparing it with other investments, if you’re just looking at the bitcoins and the shares and how other… How the residential markets performing versus the commercial market. It’s just a nice comparative way of looking at all. And like I said, go to my website. They’ve got a resource tab with hundreds of spreadsheets.

You can download and have a play and you can see these numbers for yourself. Perfect. All right, mate. Well, that actually wraps up episode three. So Steve, you’ve mentioned some giveaways. Now, what’s the website people have to go to to get these giveaways? So just go to my website, www. policeyproperty. com and there’s plenty of resources.

You can also get a copy of my book for free. So just go to the purchasing section of my website, use the code word podcast and you’ll get it for free. Excellent deal, mate. All you have to do is pay for shipping. Stay tuned for episode four, where we explain how to actually grow your commercial portfolio.

This is going to be really interesting because this is where you can really see. And plan how to actually get to where you want to go cashflow wise. Yeah. And net wealth size. We always don’t talk about capital growth enough with commercial, you still went on that front as well. That’s it. All right, mate.

Well, this has been author Steve Polisi and Andrew Bean on the Commercial Property Investing Explained series. Love it. Thanks, Andrew. Thanks for listening to the Commercial Property Investing Explained Series. This show has been produced by the Commercial Property Show Network.