Did you know many principals do not conduct proper due diligence and so, in many instances, fail to understand the real risk and real value of the rent roll in consideration before making the decision to purchase? That’s because many are unaware there are two types of evaluations. In order to make a truly informed decision as to the financial and operational viability of a rent roll under consideration, an ‘operational’ due diligence should be conducted prior to a financial due diligence.
Identifying the ‘critical factors’
An operational due diligence identifies what we call the ‘critical factors’. Identifying these can determine whether the rent roll under consideration is a viable investment that enhances your current business operations and is compatible with your business plan. This should then determine whether or not to proceed with the next step, the financial due diligence.
So, what are these tell-all critical factors?
1. Average management fee
The average management fee is the determining factor that places the dollar value on your business. The value is normally multiplied by the ‘market multiplier’ – the annual management fees multiplied by the current market value multiplier. Since your business is valued on the income generated through management fees, it is critical that this is protected and never discounted.
When conducting operational due diligence, it is not uncommon to find the management fee varies by as much as four to five per cent in rent rolls. Whilst this may be justified at the time to win business (new managements), the overall impact on your business value is disproportionate as it decreases its dollar asset value, the business value in comparison to market average and the income generated from the management.
If your managed properties are not in your defined market area (about a 10 kilometre radius), it actually devalues your asset.
2. Average distance to property ratio
Many agencies stray away from their market area because they do not manage this critical factor. Most agencies believe that all managements, regardless of location, are good managements, or they take on other properties their owners may have even if it’s outside their market area as they believe this is good business. But if your managed properties are not in your defined market area (about a 10 kilometre radius), it actually devalues your asset, increases running costs and places the agency in the high risk percentile.
3. Average weekly rent
Average weekly rent ascertains the difference between the market and agency average weekly rent. From this factor we can analyse if the rent has been significantly held back due to lack of rental increases and how this affects the purchaser’s current business operations. If the average is low compared to market average, are the managements quality managements or properties that place pressure on productivity? If rents are increased over the first 12 months to market averages, how much does that increase the asset value and monthly cash-flow projections?
4. Management splits (percentage of houses and apartments)
It costs more on average to manage a house than it does an apartment, so a higher percentage of managed houses increases operating costs and places pressure on productivity levels. For example, a property manager can manage a higher number of apartments than houses. Apartments are usually clustered so, again, this decreases operating costs and pressures on time. It is therefore also important to understand and examine the number of apartments managed within the same complex.
5. Number of owners against properties under management and how many are multi owners (including number of properties per owner)
It stands to reason that if there is a high percentage of multi owners, the risk of management loss increases if one multi owner decides to sell their properties or transfer to another agent. The higher the number of properties for one owner, the higher the risk. The higher the number of multi owners, the higher the risk.
6. Percentage of fixed term leases
Many agencies do not take into consideration the risk and effect of periodic tenancy agreements. The higher the number of periodic tenancies, the higher the risk. The greatest risk of losing a management is when the property becomes vacant. If tenancy dates are spaced out evenly across the year with fixed term dates, this lowers the risk to the purchaser. Many agents work on the assumption that it’s best to renew all leases in January as they perceive this to be the busiest time of the year. This is damaging to your business for many reasons. Examining this critical factor shows the percentage of fixed and periodic tenancies and the percentage of how many leases fall due across a 12 month period.
7. Monthly disbursement methods and timing
Many agencies disburse two or more times per month, but any more than once a month moves the business further into a risk category. This factor also shows when monthly disbursements and account settlements are processed each month. It impacts the asset value when the decision is made to sell as it increases overall operating costs, placing unnecessary pressure on time.
If records show that the arrears have not been well managed, this suggests a high productivity rent roll to manage to ensure tenants pay their rent on time.
8. Arrears management
Arrears management is well understood within the industry, but the impact on business is not so well known. If records show that the arrears have not been well managed, this suggests a high productivity rent roll to manage to ensure tenants pay their rent on time. Tenants can fall into the habit of paying their rent when and in the amounts they feel like, regardless of their tenancy agreement. This is usually because the managing agent has allowed this type of rent payment behaviour. The other risk factor is the impact of cash-flow (as you only earn management fees on rent paid) and, of course, the risk of management loss.
It makes more sense to research the rent roll you are considering investing in before making the decision to purchase. It is all too common for rent roll purchasers to pay above the real value of the business because an operational due diligence has not first been conducted. If you want to determine whether the rent roll in question is really worth the investment, identify these critical factors first to understand the real risk and real value before making the decision to purchase. For more information on how to successfully buy or sell your rent roll, contact us.