The Significance of Commercial Due Diligence - With Chris Huxter

Welcome back to another episode of the InvestorKit podcast. I'm your host Arjun Paliwal, and I'm joined by Chris, our head of commercial at InvestorKit Buyers Agency. Now, Chris, before I hand over to you, I was about to do one of these like paper things, like I'm in the news and the media. Obviously, I probably stuffed that up as well, knowing me, but hey, welcome on to another episode, man. Thank you for having me again, Arjun.

This has been great. Last episode was killer. Like we went through a deal that just looked amazing at top level. Yes. And then all of a sudden we broke it down.

It's like someone would have wasted so much time thinking that they had a chance at that. Like the pricing was a 20% variance from listing to sale price, and the net yield was ridiculous, under 5%. So this got me thinking, why don't we go deeper into this? Why don't we go into due diligence? Because that's pricing analysis.

Yes. That's net yield. But the part that where many people get it wrong, even if the net yield is good, even if they paid the right price, all of a sudden fall short on due diligence. That's right. So mate, talk to me.

What is due diligence, by the way? Like for someone who's new to commercial hearing that word, sounds fancy. Yeah. So due diligence is really going through the documentation, burying ourselves in the documentation to find what we're actually buying. So there's due diligence on a number of things.

So three main pieces is looking at the market overall. So the supply levels, incoming supply, that's one part of the due diligence. We don't want to be buying in places where they're going to be building a lot of what we're buying. So that's one part. The second part is looking into the lease documentation, looking into the history, the searches of the property, anything that maybe the property, the previous owner has built that wasn't approved.

So looking into the property itself, making sure it's structurally sound, making sure that there's no major defects or minor defects. And then the third part is looking into the lease, making sure that your cash flow is protected, protected by things like guarantees, by securities, and making sure that the rent that you're going to get is the rent that the agent is selling to you through an information memorandum. What that sounds like to me, if I'm like thinking out loud, due diligence is what you've shared with me is like, how do I have the maximum foresight possible? Yes. Because it sounds like all those areas, if you get them wrong, there's surprises down the track.

So it's like the tenant has a business stuff up and they're wanting to leave or something comes up. Surprise, no director's guarantee, no bond in place. You know, this is tough. You come in again, it's like lots of new properties out there or lots of other properties with similar vacancies, and they've been on the market for some time. And you think you've got a tenant, it's all great.

And surprise again, it's like now they're all available. It's going to take you from not your three to six months, it's six to 12 months to lease this asset. So that's the thing. If you're listening to this, watching this, and you're thinking, what the hell is due diligence? Take out all those examples Chris said.

It's like, I just want maximum foresight, right? Correct. So we're talking about only three or four out of every hundred properties we evaluate actually get through the initial steps. So the things that I just spoke about before, that is only just like a drop in the hat. We actually have a massive checklist of DD items that we go through one by one to ensure that that property ticks all our boxes.

We have a network of 500 agents. They're sending us through hundreds of property on a weekly basis. And if you're serious about commercial investment, stick around because Arjun and I are just about to take you through two deals, two case studies that looked promising at first, but didn't quite make the cut after we dug a little deeper. And that's a good point. And when you talk about those like 500 plus deals that come through, what actually people might be surprised by hearing this is that it's not the deals that come through or getting off market deals that's difficult.

It's sifting through the ones to find the one that's worth buying. Correct. That's more difficult than anything in the world of commercial. Like in the world of residential, I find it's like getting the off market is the more difficult part because you have to keep fighting the mass competition out there that's also trying to do the same. But in the commercial part, the stock will come.

You make the effort, the outreach, the discussions, but it's like when it's on your desk, it's like, is this a deal or is this not a deal? And that's what we'll go through. So mate, the first property, this is in Brizzy. And you think, hey, Brizzy commercial, let's get in there. Yeah, correct.

Crestmead, Queensland, just 30 minutes south of Brisbane CBD. We're looking at a brand new industrial unit here, great entry level property. The net rent on this thing is 63,000. The asking yield or the asking price is just under 1. 1 mil, which reflects a net yield of 5.

1. Now we have a database of cap rates and this property actually sits well within the cap rate range, the market rent range. Sorry, the market value range. And yeah, so it's neither higher or lower. It's right in the middle.

The rental increases, very attractive CPI, very good because at the moment, inflation is high or on the higher end. Outgoing structure, the tenant covers 100% of the outgoings, including management, land tax and insurance. This property is leased. It's got a fresh three-year lease and the property is about 300 square meters of space, of total space. That's broken down into an office and warehouse portion.

The office portion is 66 square meters and the warehouse portion is 230. So just hearing all that back, it's Brizzy, industrial, pretty decent rental yields at fair values. Increases are built in, outgoings are paid by tenant, healthy leases, the space is pretty adequate and it's brand spanking new in a way, right? So all of that sounds positive, right? And this is just coming back to my earlier point.

You could get into a whole bunch of positives and the deal could still fall over. That's right. So what else is, when you're breaking down this property, like some of the things that you now go flip it on its head and go, hold on a minute, but why did we not make this a deal? Yeah, so there is a catch. This deal had a few red flags that popped up during our due diligence.

The first being the tenant type. The tenant is a newly established charity. Now, nothing inherently wrong, Arjun, with a tenant that's brand new, that's a charity. However, this tenant's ABN had only been active for less than a year. Yeah, so it's tough, right?

I mean, it's not about not giving businesses a chance. I mean, obviously they've been given the chance by that person leasing it to them. So they've done their part, but it's more like this is a long-term asset and you want some history, right? Absolutely. Yeah, so to us, this raised concerns about their financial stability, which is like the most obvious thing.

And a new charity typically means they're still trying to find their footing. They're relying on donations, they're relying on funding, they're relying on volunteers just to keep the lights on. Now, I had a perusal through their social media pages and I didn't find anything that suggested they're going to get any massive funding announcements, any big donations or anything like that. So to me, that's red flag number one. That's an important one.

And so when you don't have the tenancy, have that history, what are some of the documents that you end up missing that you'd normally have when you're getting the diligence done on a property? Yeah, so this is red flag number two. Typically when we analyze a property, we analyze their rental leisure. So that's a history of a business paying their rent on time. We always do this for every single property.

If it's a brand new property and a business is either moving in or they're expanding their business into a new space, we'll request either A, their financials or B, their existing rental leisure to confirm that they've actually paid their rent on time. So we're not shooting in the dark with this tenant. Yeah, yeah. And you know, when you're doing that, right, they can sometimes be at the start of new deals, new incentives. I don't know if that was the case for this one, but that can be quite common in deal making where the deal looks sexy, but then there's incentives given to the tenant at the start and it kind of creates this false environment at times.

Do you notice that come up in deals from time to time as well? Yeah, absolutely. All the time. Yeah. And so I think when people are listening and looking at this, some numbers can look amazing, but what you can do is this.

If you grab a 6% net yield, and that's aside this deal, if you grab a 6% net yield and you see three months rent free, why not do an exercise where you go three months rent free divided across the rest of the term, and then you can understand what the true net yield is. And instead of say 6%, just for an example, it might be 5. 85. Yes. So then you should look at this as a 5.

85 because the value is sometimes do that too. They look for incentives. They're trained to look for incentives For the assets that we acquire, we like to play it safe at InvestorKit. So three to six months, we're looking at vacancies. We're typically investing in properties.

90% of the properties we invest in are industrial, and that's red hot at the moment. The vacancy rate across Australia, I think, is 3. 5%, still very low for commercial. So yeah, three to six months. And you know, with three to six months, guys, like when you're tuning in to understand, that seems like a long period.

Many leases still have option periods of about two to four months at times. And so that means tenants give us notice of between two to four months to even make a decision, and then we're able to source people, go from there. We've recently had people where it's been like a new lease come in, no vacancy, restructured leases. There's a big opportunity that goes on during that option period. It's not just a fingers crossed I get someone in the next couple of months.

And also when you're earning that high of an income in this asset type, and you don't have any vacancies for three years straight, and you have increases for three years or five years straight, all of a sudden, that could bring that end vacancy in the three to six month down to like one to three months. And suddenly that's not the actual, it's not far off from residential, right? All of a sudden with one to three months. Now that's one part of due diligence, the leases themselves. What are some other parts of due diligence that you see when you're doing it?

Yeah, so we always do like a structural report, a building pest report. So we make sure that all there's no major defects, no minor defects, or if there are minor defects, we get those things rectified. We look at the vacancy rate to make sure that when we're investing in a property, that if it does become vacant, we're not competing against other properties. We're not going to minimize the rent here. We're trying to look for things that are going to boost the rent over the long term, and that's looking for places with low vacancy, a robust asset, meaning it's not going to fall apart on you.

It's not going to have major defects, so you're going to have to come up with upfront costs. And we're also going to look into the tenant. We're always going to do a big background check into the tenant itself. Then there's also some of the other stuff, which you've got an asset here to go through, floods, insurance costs. Not that we run away from that in terms of insurance costs in commercial.

They do vary a lot, and they're higher than residential, so it's something to get used to for many residential investors transitioning. But then there are some assets where they blow up ridiculously, right? And we're just like, hold on a minute. Even if this asset's tenanted for six years, that seventh year of vacancy, let's just say that happens. We've got a fat insurance bill on our hands for our owner.

That's not on. You saw something like this recently. Yeah, so Arjun, I'm going to take you through a deal from top to bottom. We are going to touch definitely on the insurance part of things because that is a very important part to why we passed on this deal. Now, this property was a very appealing property, had everything going for it.

But I'm going to take you through the numbers, take you through how this deal looks on paper, and then we'll touch on the insurance side of things, which we'll touch on the due diligence side as well. So location, 30 minutes west of Toowoomba CBD, situated on a sizable 7,000 square meter block. It's industrial. It is leased to a very big field equipment company. They supply farm equipment, so big tractors.

They're actually listed on the NASDAQ, which is the US Stock Exchange. So we're talking about a very solid tenant company here, very attractive. They've been in this space for 19 years, so very great track record. $197,000 net income on the first year that you acquire this property. There's a five-year lease expiring in 2027, so three years remaining on the lease, five-year option to renew.

The yield is very attractive here, Arjun, 8. 4% net. Oh. That's, like, again, I mean, similar to our last episode in that first asset too. It's like great major market, international major tenant, longstanding business, huge rental numbers as well.

Now, with these rental numbers, one thing many people don't realize, in assets like commercial, if you have a six-figure passive income goal or a double six-figure, one asset can sometimes do it. Isn't that crazy? Because this asset, if it's debt-free, all of a sudden you've hit over $100K in passive income. Easily. And that's huge.

Now, on top of that, you've got five-year leases, five-year options. You could be with this tenant for another 10 years, and they've had a longstanding relationship here for 19 already. Correct. And the net yield looks ridiculous. So, like, people who'd see this would be drooling.

Yes. I was drooling. When you got all this information, this deal came to your desk, what made you go, hold on a minute, let's tear this one up and put it to the side? If it sounds like a dream, it probably is a dream. So, you know, so many properties go through my desk right now, I've kind of lost, you know, that excitement factor until I really go deep down and tick those, you know, that checklist I was telling you about, that big massive checklist, that due diligence checklist that we have.

If that doesn't all get ticked down, you know, appropriately and we're okay with it, then I don't get excited by the deal. I'm just imagining an agent call you and you're on the phone and they're like, Chris, got an off-market here for you again, $2 million, 10-year lease, brand, international, 7. 5% net, and you're just sitting there going, all right. Yeah, send it through. Yeah, yeah, cool.

Yeah, thanks for thinking of me, man. Oh, another one? Okay, man, I'll get to it. And you get to it and you're like, not you again. Yeah, yeah.

Not that due diligence again. It happens, man. That's right. So, as with any deal, we dig deeper and here's what we uncovered. So, when we reviewed the due diligence on this one, we bury ourselves in the documentation so our clients don't have to.

They pay us to do it. I love doing it. And here's what we found. In the documents, we found evidence of contamination on the site. Now, this could mean a range of issues.

But ultimately, if you're an investor relying on commercial assets for retirement income, the last thing you want to be stuck with is a contaminated site that could be harmful, that could be a financial burden. You don't want financial burdens. You want to be sipping on a beach with your margarita, you know, not worrying about this thing. Or a pina colada, right? Oh, exactly, pina colada.

That's your drink, isn't it? So, while 8. 4% net yield is undoubtedly attractive, you might even achieve 13% net yields down the track, you know, as you pay debt down, as the rents increase. The risk associated with holding a property like this one may not justify the potential rewards in the long run. What are your thoughts?

Mate, that's - so, with the contamination on the site, that was, from the looks of it, one of the core things. And as a result, there was risks on the insurance. Now, we've bought a property in this region before. Yes. That was $2.

5 million as a deal roughly, major tenant, international tenant, solid numbers. And straightaway, it was more sensible yields, right, in the sixes, not these eights and nines. Yeah, it was actually up towards a 6. 5% net yield, which is great. Solid numbers.

Now, those deals, like if you have a look at the city, the tenant, all of them, they're not two worlds apart. No. But the insurances, that was mind-blowing. When you broke that down to me, they were two worlds apart in insurance costs. What was the cost for insurance on this deal?

So, the insurance cost for this deal was around $50,000 a year. Which, yes, major red flag. 25% of rental income. Correct. That's huge.

It's not even including anything else, rates, water, nothing. No, exactly. Management, taxes, stuff like that. So, while the tenant is currently covering these costs, Arjun, there is a significant risk that if the tenant vacates, the landlord will be left to shoulder this financial burden until the new tenant is secured. And given this site contamination, there is also a slight flood risk, like very low flood risk, specifically a one-in-100-year event, so very low.

But given that there's a flood risk here, there's a site contamination, attracting a new tenant might not be easy. Especially if you're going to tell them, hey, here's your lease. Brilliant area, don't you love it? And then as you're going away, you're the agent of the leasing, and you're going, by the way, there's an insurance for $50,000. Yeah, sorry.

What was that? Sorry, what did you say? Oh, nothing, just an insurance for $50,000. And imagine, that's like a huge, it's like 25% more in rent you're paying just because of that. Correct, yeah.

So, what does this tell us?