In this episode of Property Investory we will learn about O’Neill’s beginnings in commercial property, starting with several small businesses in Perth. He shares his thoughts and experiences on leases and tenants within the commercial space, the types of loans you can take out to begin your commercial journey, yield compression, and much much more!

Timestamps:
Time | Text
2:24 | Making the Jump From Residential to Commercial
6:34 | Tenant Troubles
8:28 | Commercial Property in the COVID Era
12:59 | Vacancy and Due Dilligence
17:17 | In Property, Nothing is Guaranteed

Resources and Links:

Transcript:
[00:10:07] So, manufacturing, logistics, storage, it's all going very strong and it will continue to do so— I think— long term because it was a trend that we saw weakness in retail well before COVID. COVID's just kind of sped things up, really, in terms of pushing more people towards industrial. 

This is Property Investory where we talk to successful property investors to find out more about their stories, mindset and strategies.

I’m Tyrone Shum and in this episode, we’re continuing our discussion with Scott O’Neill, an engineer turned investor who achieved his goal of $300,000 passive income per annum at the age of 28. Hear about how he moved from investing in residential to commercial real estate, and what happens to the value of commercial property when you increase the rent.

Tyrone Shum:  

O’Neill shares with us when he realised commercial property was the path he wanted to follow, and details a risk he took early on.

Scott O'Neill:   

[00:00:13] Probably my first commercial property. So it was a small supermarket and a fish and chip shop, so two titles, two different businesses, they've both been long term. I bought the property on a very high yield, 7.58% net. And the supermarket had nine months left on the lease, but they've been there for, like, 20 years. And then the fish and chip shop, similar timeframe, he was on a three year lease. It was one of those moments where everyone said 'don't buy it', because the risk on the lease being too short was a risk. If we had to replace the tenant, that would be tricky. But we bought the property. We basically renegotiated the lease to a five year lease. 

[00:01:00] I went back to a valuer. And he said, 'yeah, it's gone up about 15%, just because you're renegotiating on the lease'. And I'm thinking developers work six months, 12 months, their life to get a 15% return— I'd just done it with a stroke of a pen. And that was exciting. But not only that, there was a seven and a half to 8% net return from day one, as well. So the ‘aha’ moment was you can actually create very good equity out of commercial, it's not just the cash flow. It was the fact that we took a property that had a weak lease and turned it into a stronger one. And that will result in making it look more attractive to the market. 

[00:01:41] Because more investors want a five year lease versus a nine month. So you can sell it for more. We didn't sell it, we revalued it again, produced equity for another day. And look, we would basically love properties. These are the types of properties we find for clients and some don't want to take those risks and just rather buy the five year lease as well, because they’re security. Everyone's got a different strategy. But that was a big moment. Because I didn't know. I'd never read in a book that you could create equity through a lease negotiation. That's new to me. And now it's just everyday life. 

Tyrone Shum:  

O’Neill goes on to detail how he came across that first commercial property he purchased, which happened to be across the country from him, in Perth.

Scott O'Neill:   

[00:02:24] It was just on the internet. I remember the days the unit block yields were not meeting expectations, I started just looking on Real Commercial and I just did everything I could to learn about it. So I learned about the office markets, the industrial markets, the retail markets, read every single thing I could. There was a lack of information out there but Google and just sheer timing pulling up hundreds of agents just working at the local sub markets and what parts were going good, where the risks were, like it was just trial and error to start with. 

[00:03:01] I landed on the fact I wanted a supermarket, or a food related business because this is five years plus ago. And I always thought, ‘food can't go out of fashion’. People have got to eat. I looked at the location, it was a fairly working class area. And that's good. There was a good trade from cigarettes from the supermarket as well, that was selling a lot of all the usual day to day stuff. It wasn't a major like Coles or Woolies. But it was one of the smaller guys, and I think that's quite recession-proof. And a fish and chip shop that's been there 20 years in Perth—if they've survived 20 years through that market, they're doing pretty well.

Tyrone Shum:  

Now with a mix of residential and commercial in his property portfolio, he explains when and how he made the decision to make commercial his main priority.

Scott O'Neill:   

[00:04:11] So 2015 is when it started, so I had I think 19 residential properties at that point. So it was a bit of a diversity play as well. And I guess if I kept going down the residential route, I would have just started creating more headaches, because residential takes a lot of management, you're dealing with tenants that come and go every six to 12 months or if you're lucky, they stay longer, but I was dealing with a lot of tenancy issues. When you own a lot of properties that are... like even the better quality ones I had, were having dramas with fussy tenants, it was always just every month it felt like I was spending multiple thousands of dollars on stuff I didn't even see or benefit from. You sort of lose touch of it.

[00:05:03] And commercial, I like the idea the tenant pays all the outgoings, the rates, the insurance, the maintenance side. It's very automated, which is great. So you're literally just collecting rent. And if you've got a long lease, you can not even hear about the property for a long time. So that attracted me a lot, because I like the idea that it could scale more. And the more I started talking to people in commercial space, the more I realised that this is where there is real wealth. There's people that you've never heard of owning hundreds of millions of dollars in commercial property, like, the old guy who's just built an industrial estate, now he owns all of it, and he's sold off portions, he's worth tens of millions of dollars. And you don't hear many of these stories, like similar level stories for residential, because most people will... some people buy 20 houses, and then what now? You don't just keep repeating the process, unless there's a bit of ignorance that there's no availment better to put your money in. 

[00:06:08] Commercial is definitely a place to put it if you want to go to that next level, commercial portfolio size, because lending is its own lending criteria, again. There's avenues to lending commercial even if you tapped out of residential. So that's important, a lot of people reach a limit with residential and then commercial is a way of going— as long as you've got the deposit, you can effectively keep lending. 

Scott O'Neill:   

[00:06:34] And just dealing with better quality tenants, like these tenants in commercial have their own business reputation. They've got Google reviews, they need to maintain that. They've got reputations, that will mean they will pay their rent if business is okay. So all you've got to do is research the business, make sure that business is okay. Just statistically speaking, out of our clients, like you could almost say we've had about 10 people out of 2,000 purchases have problems with their tenants. So the odds are pretty good. Residential, it's a lot higher, people will just get a bad tenant and have bad luck. And nothing you can do about it other than clean your property up and start again. It's just a little bit more long term, commercial stuff.

Tyrone Shum:  

With COVID wreaking havoc on the future of office spaces, O’Neill gives his thoughts on what the future may look like within the office, retail, and industrial areas.

Scott O'Neill:   

[00:08:28] This is why I like commercial because you can go into sub market. So there's three main areas— office, retail, and industrial. So we all know, office is not looking good right now. People are working from home, the CBD is quite vacant, there's a bit of a question mark on will it go back to 100% of what it was. These are reasons for us not to invest in office. 

[00:08:56] However, there's some sectors of the office market that are going very good, like suburban offices. Your local solicitor, your accountant, medical, you might have a physiotherapist, that type of stuff. So it's horses for causes, you can't kind of put it all in the same bag. But retail's another one that's kind of a little bit hit or miss at the moment. We don't do too much retail unless it's got a very solid business and they've got a good trading history and there's a good fit out and then maybe it's a high traffic area. 

 

[00:09:29] Neighbourhood shopping centres are an example of stuff that's going pretty well, as people still need to go to the supermarket. You might have a pharmacist there and a specialist there, and those types of things can work very well. What we kind of specialise in at Rethink Investing is industrial. At the moment, there is a huge groundswell of tenant demand that's being created from COVID. So COVID pushed a lot of businesses online. That means more need for storage. There's a lot less dependency on overseas manufacturing because supply chains are weaker, so that means local manufacturing is coming online more. 

[00:10:07] So, manufacturing, logistics, storage, it's all going very strong and it will continue to do so— I think— long term because it was a trend that we saw weakness in retail well before COVID. COVID's just kind of sped things up, really, in terms of pushing more people towards industrial. So I'm not saying all retail is bad or all office is bad or all industrial's good. It's just you've got to research within those markets, and you will find variances that you can't find in residential. Residential is more of an overall kind of sentiment based market, driven by interest rates and people's incomes. Commercial is a little bit more specific, but that's why I like it. Because you can research your way into a winner, and cherry pick properties a lot better, and you're not as influenced by the wider market.

 

Coming up after the break we will talk about finding the right property for the right client...

 

[00:11:27] So number one, you got to work out your budget. So a lot of our clients might be really financing from a home, and that might allow them to buy a $500,000 property or a $2 million property. 

We also discuss the importance of due diligence and how a residential investor may find differences in the process...

 

[00:14:08] It's quite involved, and every property is different, too. So this is where a lot of residential investors struggle. I've seen even experienced residential buyer's agents try commercial and they get it so wrong because they're assuming the information is correct, that's being presented to them. 

We hear more about his current successes.

 

[00:19:16] So this is what we're having some success with at the moment. We're buying properties at, say, 7%. net yields, but we're quickly seeing the market tighten where 6% is an acceptable rate. 

And that’s next. I’m Tyrone Shum and you’re listening to Property Investory.

 

 

Tyrone Shum: 
O’Neill shares his approach to the commercial market, and describes how he finds the right properties for himself and his clients.

Scott O'Neill:   

[00:11:27] Number one, you got to work out your budget. So a lot of our clients might be really financing from a home, and that might allow them to buy a $500,000 property or a $2 million property. Whatever it is, we then work out what the best property they can afford under that range is. We like capital city locations, or major regional centres. 

[00:11:51] But our strategy is to buy tenanted properties. And we want to see that there's a good tenant pool around you. So never assume the current tenant’s going to be there forever, because they're just not. In 20 years' time, you're going to have a different tenant most likely. So that's where it's important to buy good quality properties in good quality areas. 

[00:12:10] So we target properties near international airports, or close to the CBD or new massive residential estates that can be feeding people into the area long term. We don't go out to the middle of nowhere to find a very high yielding asset just because it's high yielding. And that's a mistake some novice investors make. They look at the yield only and go, 'oh, look, I needed eight or 9% net yield'. It's just silly to only look at the yield, I'd rather get a really rock solid 6.5 net yield if the tenant's well known, gonna pay uninterrupted income for the next 10 years, there's going to be a rental increase on it anyway. So there's rental growth. All of a sudden that face value yield is not as important. It's more about the growth, if anything, and the consistency of income. 

Vacancy and Due Diligence 

Scott O'Neill:  

[00:12:59] So we always look at it from that point of view, how quickly could we re-lease the property? That's how I approach my investing and our clients'. And if you're happy with that, if it's, say, we predict it's going to be a two month vacancy if we lose this tenant, because the neighbor's property got leased out in two months last year, or maybe we've seen 10 different examples where some rented in one month, some rented in four months, some rented in three, you average it out. And you can actually work out, or at least predict, how long the vacancy would be. 

[00:13:32] And as long as it's not a crazy time, you can then put that into your due diligence model. We call up the tenants, we work out their succession plans, we do a competitor analysis, we do credit checks on businesses, we check the square metre rates on the lease, we get the lawyers to do legal lease reviews. We will go into every little legal part of the property, make sure all the structures are approved, if they're not, make sure it's not counted in the valuation, get the builder out there, check it's all up to date, modern, compliant. 

 

[00:14:08] It's quite involved, and every property is different, too. So this is where a lot of residential investors struggle. I've seen even experienced residential buyer's agents try commercial and they get it so wrong because they're assuming the information is correct, that's being presented to them. And you can't do that. You've got to actually go through every rates notice, check the insurance is valid, check the tenant's paid for the last few years in a row, uninterrupted. Have they had COVID relief payments, all that kind of stuff. So it's a lot more time consuming, which turns people off.

Tyrone Shum:  

With residential differing so greatly to commercial, and ever-changing lending processes, O’Neill explains full doc and lease doc loans, and how he finances his commercial properties.

Scott O'Neill:   

[00:15:06] So the two main ways are a full doc loan or a low dock. Full doc is you just show your financials. So if you're on a salary, use a full doc loan, you'll get a very good interest rate. We're seeing anywhere like— this is, end of 2020, we're seeing rates as low as 1.8%, all the way up to about 5%. Average is around 3%. But that's starting to get on the high side at the moment. So interest rates are very good. 

[00:15:35] If for some reason, you have a cash deposit with no job, or a cash deposit, and you're in between jobs, or maybe you're a commission only type person, it's going to be hard to get a full doc loan, but you can actually get a lease doc loan. What a lease doc loan is is a loan on the property itself. So you come up with a deposit, but the strength of the lease is enough to give you a loan on the property. This is very handy if you've reached a limit with your residential lending, because you can actually get a loan outside the normal lending criteria. And again, you just need the deposit as something to invest in.

Tyrone Shum:  

Valuations also differ between residential and commercial properties. O’Neill discusses those differences and the importance of getting a solid valuation.

Scott O'Neill:   

[00:16:25] Valuations are a lot more detailed. They can be 50 pages long. And you'd basically get them as part of the lending process. So it's a good part of due diligence as well, value is by nature. And they're going to be conservative. So we can sometimes use a short valuation as a negotiating tool to get money off the property. But yeah, most of them come in at contract price. You've got to pay for them, they're about anywhere from $1,000 to $3,000, for the average property, but it's all factored in when you're doing the initial loan application. So if you buy an expensive property, and you spent $1,500, dollars on an evaluation, it's very good peace of mind, as well. And the bank wants to see it, so that'll be a safety net.

Tyrone Shum:   

[00:17:17] So let's say for example, we've got a property that you've just purchased— let's just make it round figures, $500,000. It's yielding about a 7% yield. You put a little bit of work and effort into it to bring up the yield to maybe say, 10%. Does that also change how the property is valued in the future? Like, would you be saying you could get capital growth through that way as well?

Scott O'Neill:   

[00:17:37] Yeah, so, if you've got a $500,000 property, and it's 7% return, let's say you've got an interest rate of 3% on that, you've got a 70% loan. That's going to give you about $28,000 clear per annum, in your pocket. So if you somehow increase the rent, let's say it's double, you're going to double your price. So it might take you 10 years to get your $35,000 net income to, let's say it goes to $55,000, the value is going to be quite closely aligned to that rise in rent. 

[00:18:18] So you can actually get—I don't like every use of the word guaranteed, because nothing's guaranteed—but when you've got a lease, and it's got a locked in 3% or 4% increase per annum, that's how much your rent's growing each year, and it's scheduled. There's no way the tenant can get out of that, unless you agree to it. That means you're going to get three to 4% growth just on the value of the rent. The other growth is going to be yield compression. 

[00:18:44] So what your compression means is, let's say you've got a 7% asset. If the yield drops in the area to 6.5—so everyone's now accepting a 6.5 cap capitalization rate— the property is no longer worth $500,000, it's now worth $538,000. If the yield drops down to 6%, which people are happy, the property is now worth $583,000. So you can see the cap rate is really important for valuation. 

[00:19:16] So this is what we're having some success with at the moment. We're buying properties at, say, 7%. net yields, but we're quickly seeing the market tighten where 6% is an acceptable rate. And in that $500,000 example, a yield compression of 1% equates to an $83,000 value increase for every $500,000 you purchase. So that's equity that you can use and leverage off and go again. Especially considering the income of these properties are good, your lending scenario, although it is more complex, is more favourable in many cases, because you've got higher net incomes to lend against.

 

Scott O’Neill’s story continues in the next episode of Property Investory. Join us for part three where we’ll talk about the differences between residential and commercial properties...

 

(Snippet from part 3 episode)

[00:07:07] These things actually add value to your property, and you can take it to the bank and refinance and go again, in many cases. So it's just like residential, but it's probably a little bit more instant when you get it right.

 

The types of people who buy and sell commercial property, and who you can generally find within price brackets...

 

(Snippet from part 3 episode)

[00:21:06] So with the super high value stuff, it's commonly syndicates. So managed funds, and they're actually just divesting their asset, moving on to the next one. So that's your $10 million plus range, generally syndicates, with the exception of a couple of high net worth— but not often. 

We discuss the benefits that O’Neill’s portfolio has given him and his family.

(Snippet from part 3 episode)

[00:33:16] Ever since I started the business with the exception of this year, I've spent three months overseas where I literally barely do any work. So if we were money hungry, we wouldn't do that. We would literally stay and work, because that does cost the business a lot of revenue every time we do that. But it's enjoyable to do that. 

 

And that’s next time on Property Investory.