I have recently assisted a number of clients with the sale and also the purchase of a number of commercial properties.
There are some clear differences between commercial and residential property.
A key difference is that a commercial property is often valued on the basis of the cash flows due under the lease of the property. This means that the validity of the lease, the key terms of the lease and the stability of the tenant are all typically key issues when buying a commercial property.
To illustrate this, I recall the instance of a client who purchased a commercial property for $1 million. This value was based on a lease with an annual rent of $70,000 – and based on a 7% yield, this justified the purchase price. The problem was that the tenant wasn’t overly stable – and a little over 6 months later the tenant went into liquidation. The client then had a vacant property – and even worse, discovered that the market rental for the property was more like $50,000 per annum – and at a 7% yield the property was not worth a little over $700,000.
This is one reason why sophisticated purchasers of commercial property often undertake a more thorough due diligence of the property – as well as the lease and the tenant.
However, as the purchase of residential properties increasingly means a 7 figure price tag, what lessons can residential purchasers learn from the practices of commercial buyers?
Due Diligence
Typically, the purchase of a commercial property is subject to a due diligence condition. This allows the Purchaser to thoroughly investigate the property, the leases, the development potential and much more before the contract becomes unconditional.
By way of contrast – many residential properties are sold at auction. The client typically inspects the property for little more than 30 minutes (and usually isn’t very thorough) and then, if successful at auction, signs an unconditional contract.
When you think about it, from a purchaser’s perspective, this isn’t a great process given the significance of the transaction and the likely price tag.
Valuation
Often the purchaser of a commercial property will commission a valuation of the property after the contract is signed. Commercial valuations tend to be more robust than residential valuations – and if the valuation doesn’t support the purchase price then the purchaser will typically use the due diligence condition to either walk away or negotiate a reduction in the purchase price.
Again, in contrast, most residential purchasers are hoping that the bank will accept the contract price as being the market price. There is some logic to this – as the market price is what a willing buyer will pay – but I think we are all aware of auctions where the bidding got out of hand and the price doesn’t reflect perceptions of market value.
Inspections
Sophisticated purchasers of commercial properties often have the property thoroughly inspected for defects, potential problems and any failure to comply with building standards or other regulations. The resulting report is often sent to the vendor with a request to rectify the issues discovered in order to satisfy the due diligence condition.
Residential purchases proceed on the basis that any defects are, with limited exceptions, the purchaser’s problem. It’s only major defects that may give rise to a right under the contract to terminate. Residential sales have, in simple terms, always been conducted on a caveat emptor/buyer beware basis although there are some recent legislative changes that have made some limited inroads into this.
Overall
In summary, sophisticated commercial property purchasers conduct a much more thorough due diligence into the properties that they purchase. This reflects, in my view, more experience buying property and therefore awareness of what can go wrong, a different market that is accepting of greater due diligence as well as an awareness that property value is driven by rental cash flows.
We encourage all of our clients to fully and thoroughly investigate the properties that they purchase. We can assist with a review of the purchase contract – click here to book a review online. As a client summarized this – the difference between investing in property and speculation is due diligence.
As always, Lewis O’Brien & Associates stands ready to assist with commercial property purchases and sales – whether it be conveyancing or helping out with a sticky situation. If we can be of assistance, please contact us – or you can book time with me by clicking here.
The most ridiculous thing…
This week we had a client who bought a house subject to a building inspection condition. An inspection was done by someone who advertised themselves as providing building inspection services. Three major defects were identified. The purchaser sought a reduction in the purchase price as a result.
The Vendor’s representative made the point that the inspector wasn’t a registered building inspector as required by the standard building inspection general condition and tried to assert that the building inspection condition was now satisfied.
The client was distraught – but we pointed out to the vendor’s representative that we could have a registered builder do another inspection and effectively endorse/reissue the report. Eventually the vendor’s representative conceded that this was unnecessary – and a discount acceptable to our client was negotiated.
This is an illustration of the importance of technical compliance with contract conditions – and a shame as the report was one of the most thorough pre-purchase inspection reports I have seen.
Next Time
In our next newsletter I will work through the tricks and taps of the standard finance condition. If you missed it – we recently reviewed the standard pest and building inspection conditions here.
Lewis O’Brien
Your Preferred Property Lawyer