Archive for March, 2010

Buy into Real Business

Martin Hawes is a Queenstown based financial adviser and author who recently advised his readers to buy into ‘real business’ he defined as real property or commercial as the forthcoming tax changes were sure to change the residential investment market as substantially as the crash of 1987 ended NZ’ers enthusiasm for the share market. Commercial property he reasoned offers better returns, the management is easier and the tenants are generally better. I would assume that the last qualification is because the tenant relationship was subject to a more robust and landlord friendly lease agreement for longer terms than a residential tenancy.

A Shape NZ survey published last month that 44% of residential landlords and 55% of NZ’ers agree that depreciation allowances on rented houses were unfair presumably because only a few residential properties actually depreciate in the longer term. So the government probably doesn’t need further support to take away depreciation allowances from residential investors. What is not clear however is whether they will still allow for depreciation on chattels and fitouts which can reasonably be shown to deteriorate. I can only assume from what I have read in the TWG paper and elsewhere that it is likely that commercial property will also lose depreciation allowances too.

So what might these changes mean? Lets take a couple of examples I have found from the For Rent pages:
Example 1; 2 bedroom unit in Petone: $350/wk x 50 weeks    $17,500
Rates                $ 1,946
Insurance          $   444
Net Income      $15,110
Depreciation (VI =$175,000) x 3% dv    $5,000
This property currently returns 4% on its current RV and 6% over it’s purchase price in 2004. Depreciation amounts to 33% of its net income.

Example 2; 2 bedroom new apartment Wellington city:
Rents $650 per week x 50    $32,500
Body Corp             $ 2,400
Rates                       $ 1,768
Net Income           $ 28,332
Depreciation (VI = $335k) x 3% dv        $10,000
This property currently returns just 5% and my estimates suggest that the depreciation allowances which will be lost could amount to 36% of the net income. These calculations would be much higher if chattels and fitout allowances are included. Please remember these are book value estimates, not cash flows which will depend on the individual investors marginal tax rate. Investors Associations and the like have declared they will attempt to recover lost income from their tenants. In this last example this amounts to $76 per week(assuming a marginal rate of 38%). We’ll have to see if the market allows for that.

Dramatic figures explaining the dramatic fall in properties sold in recent months. But what then of the commercial markets? Well applying the same methodologies to a Petone industrial property available for sale at 9% of net income, the depreciation calculated on a proportion of the sale price and not the outdated RV could  amount to 24% of the net. And likewise a Wellington city office tower for sale currently at 8.75% of net could lose depreciation being 27% of the net income. Again these figures will vary depending on whether or not chattels get excluded as an allowance.

Martin Hawes was right! Buy commercial!

March 22 2010 | Uncategorized | No Comments »

Own yer own office floor – it’s just good sense right?

A friend of mine recently chastised himself for not purchasing a small commercial property which sold for $700,000 some 6 months after I reported the asking price to be $1.2m. On the surface of it I can see his point, it does seem a bargain but is it right for him? Well lets see using my estimate of opportunity cost based on the interest rate and a little premium for risk of say 9% we have;
Cost to service $700k            $63k
Rates                                   $15k
Compliance and Insurance    $ 3k
Total Annual Cost in lieu of Rent    $81k

Now given that his current rental budget is $60k and he is hoping to move for less than $50k I told him he is far better off leasing his premises than looking at owning. Sure he is giving up the potential of a capital gain which has in the past a proven over a longer term but he is gaining considerable flexibility and choice with a number of  leasing options to locate his business. It’s an older building so 3% depreciation on the Value of Improvements (VI) is only $8k but this deductibility will certainly not be available in the future. Plus he would inevitably face the requirement to earthquake strengthen the building within the next 10 years.

What then of office tenants? Is it better to own your own office floor unit title in the city rather than pay the rent? And what of the new tax changes allowing deductions for depreciation on buildings, how will that change the viability of ‘own yer own’?

Owning your own home is a deep part of kiwi culture, the quarter acre paradise etc. but it is not a major feature of the Wellington office market with only a small handful of central city buildings held in unit title or company share structures.  Most CBD building owners are wealthy individuals or corporations who enjoy huge capital gains particularly when the market is on the up. So instead of funding someone else’s wealth why wouldn’t a savvy business owner want to create their own? I currently have 2 interested office tenants who would love to find suitable and affordable unit titles but alas my search is proving difficult with a lack of stock.

At the height of the market (2007) we can see sales of unit title floors tipping $5100 per m2 however the last sale in the same building last year was for $4000 representing a drop of 20%. I wondered if the current market represented good value? Lets look at an example using $4000 per m2;
Cost to service purchase $1m        $90,000
Rates and Body Corp                    $17,000
Total Annual Cost in lieu of Rent    $107,000

In addition these floors would have been purchased with an expectation of depreciating the building value calculated at 3% diminishing value or say $17k based on the current VI.  While that’s not an actual cost it does represent a cash benefit of $6500 based on the top marginal tax rate of 38%.

Now complicating matters further there is space to lease in this same building right now for $70-$80k per annum gross. So given the short-term difference of say $20k in favour of leasing can we say of the perceived wisdom of ‘own yer own’? The reality for most businesses and particularly anyone related to the IT sector, their outlook is subject to change where they will need to expand and retract staff numbers and overheads with some degree of fluidity. Owning your own commercial space is a great idea for an exit strategy for your business (e.g. selling the business but keeping the real estate with a long term lease on it) but it doesn’t necessarily allow for the flexibility many businesses would prefer. Until unit title owners realise that 2007 valuations are meaningless and 2010 values must account for new rental realities and the loss of depreciation, I suspect my 2 interested parties will stay in the leasing market.

March 18 2010 | Uncategorized | 1 Comment »

Bouncing along in a trough….

We may be officially out of recession but a recent consumer comfort index probably says it all with a score of -18% suggesting consumers are finding economic conditions tough and that it is not a good time buy larger items. Another ANZ confidence survey targets medium sized businesses who were more positive than negative however the ANZ economists still set the scene with the heading ‘Southern Chill’.

The residential property markets likewise are in the doldrums. John Key and the Tax Working Group (TWG) combined in January to kill investor enthusiasm with the impending loss on tax deductibles. Residential agencies report listings surge (up 47% from January) and sales stall, the February median price was 7.7% down from January.

The best we can say is that we are bouncing along the trough of the real estate and economic cycles. I think the TWG’s suggestion of the introduction of land tax and CGT and eventual confirmation of the loss of depreciation has created the biggest hit to investor confidence for probably 20 years in this country. The government is determined to take heat of the housing market and force down the affordability index as encouraged by bank economists and the capital markets who mourn  the loss of investment in the share markets.

What of the commercial real estate markets? I think the potential for 2010 is immense. Commercial offers higher returns, better tenants and easier management. There has never been a better time to secure cashflow positive commercial property. When can you say that about residential?

The biggest challenge has always been to secure reasonable quality stock as vendors hang onto expectations based on old valuations. However a number of Property Funds will have to downsize their portfolios this year in order to cut debt and I have no doubt bank pressure will be brought to bear as further valuation write-downs and vacancies cause mortgagee nervousness. In terms of activity 2010 could be a record year!

I see canny investors leaping before the herd and trading out of residential or out of small commercial to large where the returns are best. A number of vendors will take residential portfolios as part trade where they have the capacity to sit on the properties  and sell down when that market recovers. So try your luck! Smaller investors ($50-500k)also have the opportunity to buy into securitised funds and therefore gain exposure to better quality property. These funds are usually run by experienced players with an eye for a good bargain and management experience.

Hang on 2010 is going to be bumpy!

March 10 2010 | Uncategorized | No Comments »