This episode was recorded on the land of the Wurundjeri people of the Kulin nation. We pay our respects to their elders past, present, and future.
Richard: Hello, and welcome to another episode of Precisely Property. I’m your host, Richard Temlett. I’m excited to have you with us today. If you’re here for the first time, thank you for joining us. I encourage you to listen to our previous episodes where we discuss all things property with a focus on dynamic discussions with industry leaders. In this episode, we’ll be discussing Build to Rent (BTR) and how to maximise Net Operating Income in a BTR asset with Dominic Martin of GAA. So sit back, relax, and let’s get started.
Residential investment and operational market expert with 20 years of real estate sector experience, Dominic Martin’s capabilities range from commercial rental operations to writing national housing policy. Dominic is a leading industry figure involved in numerous industry bodies, driving new initiatives and authoring research publications. Dominic is Managing Director of CompassRock International, a firm that provides asset management and property management services to rental housing sectors, as well as Global Apartment Advisors, a London based advisory firm focused on the living sector globally. A member of the Royal Institute of Chartered Surveyors, Dominic’s expertise includes operational management, investment, development viability, and government policy. He was one of the founding members of the UK government’s PRS task force and is currently a member of the IPF Special Interest Group, the BPF Build to Rent Subcommittee, and the Association of Rental Living. Welcome, Dom.
Dominic: Hi there. How are you doing? Thank you for inviting me.
Richard: Dom, as we discussed offline, in today’s episode we’re going to talk about how to maximise Net Operating Income. This is really timely in Australia given that the first round of projects have started to be complete and are being leased up and are getting close to stabilisation. And I do a lot of work with the financiers and a lot of them are from overseas, and they are certainly testing the investment thesis of Build to Rent and the platforms. Particularly, they’re asking to see under the hood of how operators are going to maximise Net Operating Income. I can’t think of anyone better placed than yourself to talk about this given your years or even decades of experience. So, I can’t wait to get into that. And we’re obviously going to talk about some lessons learned that can be applied to Australia. And I’ll have your links as well as GAA and CompassRock’s links to where everyone can contact you because no doubt, they’ll be wanting to pick your brain a little bit in more detail and commission you for some advice.
But before we get into that, I wanted to ask you an icebreaker question. And that’s as follows: You’ve worked across so many parts of the property sector, from government policy to development delivery. If you could pick one moment from your career so far that really surprised you or changed how you saw the industry, what would that be?
Dominic: Cool. Yeah. Sure. So, Richard, my background as I think you covered. It was originally commercial real estate then I qualified as a Chartered Surveyor. And in fact, I moved to CBRE soon after I qualified, spent six and a half years there. And it was during that time that I switched from commercial to residential, and it was one stat in particular that just totally threw my mind. It was that in the US, real estate investment, which covers offices, shopping centers, industrial, hotels, all the use classes that you traditionally imagine, one third is residential. And in fact, the residential investment market in the US is the same size as the office investment market. And so, starting out as we were in the UK, where we had at best 1%, maybe 2% of the total real estate investment market was residential, the opportunity for that market to grow in my mind was huge. It would dwarf previous different kind of booms, big shopping centers or out of town retail warehouse parks. This sector, it’s a career and some. And so it was with that, and good being at CBRE during the financial crisis, where the British government had decided that it needed more institutional investment in the PRS or Build to Rent as that branding or name has evolved, that I started to pivot. And that experience included working with some of the big landowners in the UK and London, Argent, Quintain. The government had asked for expressions of interest from parties to come forward to help build a new sector. This is throughout 2009-2010. At CBRE, we got partnered up with Aviva, and they got very close to launching a fund. It was all very exciting. And during that process, they appointed a US operating partner, a company called Pinnacle, now owned by Cushman’s. And they came to London, and their experience visiting the city, what subscribes as a top three global city, they were so surprised by the supply and demand dynamic and the imbalance that we have here. They remarked over dinner at the end of the week that not only was that supply and demand dynamic totally out of kilter that the quality of the apartments available for rent, they were staggered somehow that you could find carpets in bathrooms, which they were a little bit perplexed by, but also the quality of service. As most people know, the British love to queue. We’re not very good at complaining about our food, and the whole thing meant that they were so keen. They said this was one of the biggest no brainers they’d ever seen. And so that dawning of the start of the market, that rush from 2009-2010, seeing all those things come to pass, that was a bit of a no brainer for me to switch from commercial to residential.
Richard: Great. That’s a fantastic answer. And I suspected that you would have said something like that. And I’m always astounded when I look at the size of the residential sector overseas and hopefully where it can go. And I do believe it will get there in Australia. Before we get into the actual main segment of today’s discussion, just for the audience who have not listened to the previous episode with David from Global Apartment Advisors, David Woodward, who is the CEO, can you please give us a quick introduction to GAA and what the organisation does?
Dominic: Global Apartment Advisors was set up by David, perhaps seven or eight years ago now. He had been previously Global Head of Residential at Brookfield. And in fact, it was his time in Australia working with a few local developers, who said, “David, if you ever thought about becoming a consultant, they would hire you in a heartbeat.” And with the extra travel and the burden that came with that, he decided to create Global Apartment Advisors out of Denver and started to travel a bit, and more into Europe. And through that experience, moved lock, stock, him and the family, got his British passport, imminently, settled, and he and I became business partners. And we together continued what he’d already started. I’ve had clients across the world, New Zealand, Australia, as I mentioned. But David has spoken in China, India, a lot of work in Spain, Ireland, Italy, and effectively the wave of residential investment and the interest from institutions across different markets that continues globally. And it’s a very exciting time.
Richard: Great. Before we get into the discussion about Net Operating Income, the reason why I was very keen to get you on the show and as I was talking to you when we were preparing for this session is that in the UK, the BTR sector is about one to two market cycles or even more ahead of Australia. You’ve obviously lived and breathed this for a number of years. And I’m hoping that you could talk a little bit about some of the projects, new or even slightly old, that you’ve been involved in to give our audience a bit of flavuor. And why I particularly say that is because when I’m doing a lot of work or research in Australia, I must admit some of it is still quite academic. And it’s academic because we just don’t have assets that are as mature as yours. I think there’s been one that’s been traded. They’re still leasing up. So, maybe one or two examples of your favourite ones or the ones that are the most diverse or challenging that you’ve either worked on or are working on.
Dominic: Sure. I think it’s two parts. You mentioned that we have another business called CompassRock, and we have a joint venture with an investor. In fact, we have almost 1000 units now under management in the UK. And as that CompassRock business is circa three and a half years old, the brand is actually a legacy brand that David had created in the US. So, it’s that current universe that I oversee, but also the legacy of how I got here. And I’ll start with that simply because the emergence of Build to Rent in the UK naturally led with London, Manchester, Birmingham, the big cities of course. I joined a family office, post my government task force stint. The family office I joined were buying offices that were being converted to residential. The government relaxed the planning rules around conversion of offices. We had a lot of secondary redundant office space that was dragging down commercial office rents. We need housing, so the government relaxed the planning rules. There’s been a raft of office to potential conversions in the last 10 years. The family office, we had five. What was interesting about that was that all of them were in quite secondary, if not tertiary towns in the Southeast of England. I don’t know how many of your listeners have been to the UK, but places like Crawley, Stevenage, Bracknell, they’re not the most glamorous of locations. But what’s interesting about them is they’ve got a very strong jobs market. And my shift from commercial to residential into the late noughties, valuation was a key consideration. How do you value this asset class? We’ll come on to a bit more of that on the NOI chat. How do you understand the covenant strength? What is the cap rate investment yield that you should put against this income stream? And so commercial, if it’s Google or HSBC, it’s very strong. If it’s Mr. and Mrs. Smith, and it’s a small barbershop perhaps or small business, that risk profile, that income changes.
And so in residential, how do you underwrite 100 tenants or 150 tenants? It’s quite tricky. But the reality is if you’re in a market, a jobs market, which is very strong, that is high employment, if someone were to lose their job, a tenant of yours loses their job, can they find another job quite quickly? Or do they have to move? There’s a bit of a queue that people want to move in. And so that local jobs market, and I was involved in a Swiss fund called Achilles, who started buying in the UK 2011. Again, I was in CBRE at the time. And one of the assets they bought was a town called Horsham, very close to Gatwick in Crawley. So in the middle of nowhere, not an obvious place to invest. But an existing asset, it was about 40 years old, and the jobs market was phenomenal. And it had done really well during the GFC, Great Financial Crisis. And so there was a feeling that this would be a good investment, and so it turned out to be.
And so that experience with Westrop, the family office that I was at, these office to residential conversions, the local rents were somewhat suppressed. Estate agents are not really geared up to push in rents, the way their fees are structured. They’re not incentivised to perhaps push for another 50 or 100 pounds. They just want the speed of turnaround. And so the affordability we found in our own portfolio too, of a lot of couples. It’s not one income. It’s two incomes. And so the early stages of my career in Built to Rent, seeing the opportunities in perhaps secondary, tertiary towns, which you wouldn’t normally expect to invest in, not building a thousand units, building perhaps a 100, 150, 200 units. There is demand for decent rental accommodation with good service. It may not be over ammenitised. There’s perhaps an obsession with amenities that has come from the US, from study tools. But with smaller properties, you can still make them functional, good looking, with some meaty offer, but you don’t need all the bells and whistles. And so that rental performance we saw in those small towns has actually led to what we do at CompassRock and our investment strategy, which is very Southeast orientated. We now actually buy in London or the big cities, but there’s also equal opportunity elsewhere.
Richard: Great. Okay. Well, look, let’s get into the session because I can’t wait to hear what you have to say about Net Operating Income. So let’s start with the basics. What is Net Operating Income?
Dominic: Sure. So, I’ll probably start or perhaps in a second, go into how it’s calculated. But the principle being, you have your revenue, your headline revenue, and then you deduct all your costs, and you end up with your Net Operating Income. The slight challenge is how it’s calculated. Some, in quite a crude way, would look at the headline rental, the ERV, Estimated Rental Value across a 12 month period, tally up all the different costs that make up a budget, so your operating costs, contract services, insurance, staff costs, your management fee, but also then add on top of that your void and bad debt. That might get to a total, and the percentage could be, let’s say, 25-30%. That figure is deducted from that headline rent number. That’s a bit too crude in that you should be taking the headline rental number, deducting your void and bad debt, giving you a net rental position. And from that net rent, you deduct your operating costs. So, effectively, you’re spitting out void and bad debt. There’s a deduction from headline rent, and then the other bucket is everything else. But by amalgamating void and bad debt and dropping your costs into a single global number, deducting that collectively off the total number, it’ll give you an inaccurate figure. Hope that makes sense to you, Richard. We put on the screen yesterday, and one thought was might we share some notes, after the call to try and illustrate that in a bit more detail.
Richard: Look, I’d love you to please do that. And I must admit, I am not a valuer by background. I’m the researcher. I have had to peer review various valuations in Australia and I’m pretty sure they’re not doing that, or at least some of the ones that I’ve seen. I think that they do have it reversed. And I’m glad you raised it because when we were preparing, you raised it and I went, Oh my goodness. And as I was preparing for this again today, I looked at a few of the valuations. And perhaps the same thing happened in the early days in the UK where it wasn’t accurately calculated. So that, I think, in itself is very interesting. And you did have a couple of scenarios. So, yes, we’ll be able to put that as a link, just as a PDF document or something in the show notes because I think that’ll be the starting basis. And as you said, we’ll get on to how we value these things, because you had quite a lot of good and bad to say about how we value these things. But as a starting point, I think that’s really important.
Can I ask again simple questions, but let’s start with the basics? Why do you need to maximise Net Operating Income?
Dominic: I mean, ultimately, the perspective I have, so for the investor, and we talk to other investors as well at the moment, our duty of care is to maximise those returns. That’s where it boils down to. We’re hired on the basis that those investors think we can do a good job. Therefore, we need to do that. And the reality of how you maximise net profit income, there are two points you can focus on.
One is growing rent. The other is reducing cost. And as I was showing to you yesterday, Richard, it can be the case, and it’s only happened in the UK, that there can be a natural focus at the start on cost and reducing cost and a great debate around how many staff you should have on-site. So in the US, the ratio, give or take, is a member of staff for every 50 units, and that ratio split will be between front of house and back of house. That’s quite an easy metric to start to think about staffing. But staffing is your biggest cost in your budgets, and so can you reduce that staff count, have people part time, perhaps? It’s a bit of debate. The view that we’ve taken with our own portfolio in the UK is let’s focus on revenue first. And the first senior hire we made was someone with revenue management experience, who’d worked in airlines and hotels, but also worked in the US, US Multi Family and overseen revenue management for 26,000 units. So someone joined the company, and that’s what we focused on.
And we’ve since brought in more people to focus on the operating budgets and see where we can find those savings. But we’re outperforming our business plan on Net Operating Income because we’ve got a strong focus on revenue. And part of that relates to brand new buildings, how long does it take to lease up? You can lease up in three, four, five months, or could you take longer and hold your nerve and hold rate? And the strategy we have taken is to hold rate and take maybe 12 months, perhaps even a little bit longer to lease up.
Richard: Let’s talk about that Dom a little bit more because I’m literally having those debates exactly as what you said. There’s two schools of thoughts and certain operators are going one way or the other. So obviously, please keep going because there are literally people hopefully that are jumping out of their skin wanting to talk to you about exactly this point.
Dominic: So, part of it may relate to the underwrite or the business plan that was first created when you were looking at a land deal or development deal or forward funding. And might someone have said, will this lease up in three months? And that was a key ingredient going into that underwrite that perhaps helped turn ahead. So, some might have baked it in, not perhaps realising the implications. If your whole period is three, five years, got a bit more time, the difference in getting another one or two or three, five, ten percent more on rent is far more accretive to investment returns than leasing up in just three months, say. And so, it really is a sensitivity analysis around lease up cadence and pushing rent.
The nervousness, of course, is the unknown of how much you can push rate and rent. And so in that absence, it may be a case where, okay, we think we’ve got confidence that through the comps, rental comps and local market, here’s what we should get. That makes the returns work. We could lease up in three months. The view that we take is when we hear these stories of quite speedy lease ups, in our mind, there’s rent that’s been left on the table.
Richard: Very interesting.
Dominic: And then it takes time to claw that back, if you can at all, through renewals and rent increases thereafter. Once you’ve baked in that base rent number, you benchmark off that thereafter. It is hard to claw it back and outperform once you’ve baked in the first lease up.
Richard: Dom, would your advice be the same for an emerging market like Australia now versus the current mature market in the UK? And why I say that is because there’s a bunch of operators who are basically going, the rental market doesn’t fully understand or value Build to Rent yet. And if we hold our weekly rents at the premium, the market is going, “Wow, that is very high.” Some of the logic was, let’s get them into these buildings, let’s get it stabilised so that we’re building up the brand. Is your advice still quite consistent saying take it a bit slower, or is it different in an emerging brand or emerging market or asset class?
Dominic: Yeah. And I can appreciate the logic and understanding that some may have around a nervousness of pushing rate too hard and being left, with a building that is part empty. And we’re certainly sitting in Dublin, where we operate now as well, where there’s been perhaps too much of a focus on pushing rates too high. That’s played down to rent control, that exists in Dublin and Ireland. What we’ve found is, and I don’t know how cyclical the Aussie market is, but I think most people know the British winter is pretty miserable. It rains a lot. It’s quite the hockey stick in terms of when you hit spring, the clocks go back, you get the longer evenings. Our lease up rate, the number of inquiries you receive, number of viewings that get converted, and then applications made, those three stages of the leasing process. Our application rate jumps to the roof as we hit May, June, July, August. And so, we’re leasing up a building right now in Bristol. Hit the press. We’ve acquired this asset off a developer. Hit PCs, hopefully today, maybe Monday. On the knife edge as to whether we get that today or not. We’ve been pre-leasing. We’re about 5% ahead of our underwrite. We’ve been pre-leasing, the journey so far has simply been the show flats. The meetings haven’t been ready to view at all, so we’ve been pretty pleased with the stats so far. Around 15-20 units pre-leased over about six weeks. So, yeah, not rushing. The meetings open up hopefully today. That should allow a bit more of an exciting and better sales process. But we know it’s 295 units in Bristol. We could try and lease that up by the end of the summer, but might we leave money on the table? And so the underwrite allows for effectively two seasons in spring/summer. So it’s a 15 month to 18 month underwrite. So effectively then try and make hay during the summer. We’re going to hire extra leasing staff, so we spend more money on our renovation budget and have more leases because we know we’re going to peak season. That will then tail off in the winter. If we get to 70% leased up, great. If it’s more like 50%, 60%, not the end of the world. We’ll play catch up next spring. And so the importance of trying to hold ratein our minds is our strategy.
A lot of it comes down to the leasing process. And what we’ve found in Bristol, for instance, we sent a couple of our leasing team out to mystery shop, and the leasing journey and some big name brands was not easy. To get a viewing was hard work, lots of gating, questions, preselection, but even on the day, the actual viewing wasn’t great. And so what we’ve come to find, and it’s certainly true, is that so much effort and money goes into designing these buildings, getting the financing, getting planning, getting construction. Construction’s hard work. The moment when the rubber hits the road to really crystallise his returns, the leasing team, is there enough people? Are they trained enough? Do we understand sales? We’ve had our trials and tribulations with our leasing hires. But if you rush too quickly, have you come short on what was possible? And so when we mystery shop, this is a GAA service that we run. We’ve done this in in the UK, in Spain, and in Ireland. We’ve discovered that this nearly isn’t that straightforward. If our own websites at CompassRock, if you want a book reviewing, there’s a front-page book a viewing. It brings up a calendar, and the consumer gets to pick and choose the date and time that suits them. It’s locked in. There’s no back and forth on emails with our centralised leasing office. It’s just get the viewing booked in, allow them to tour, and then sell the building thereafter. I think there’s a bit more perhaps thought. If people are struggling, rather than paying lower rate and lower rents, check how the leasing journey is working out.
Richard: Great. What are your views on offering incentives? Have you seen that emerge? Because I must admit, it is starting to occur, in certain projects in Australia. So, what are your views on that?
Dominic: Definitely, we use them. The aspiration is that the rent level, the asking rate, is held for as long as possible, and they use other incentives to try and get a deal over the line. Now you can include rent free as an option. But before you get there, we buy our broadband in bulk, and we charge for it. We don’t include it in the rent. If you want furniture, we don’t furnish our buildings 100%. If people want furniture, they could rent it off us, and we buy it for them. But can we discount the broadband or discount that furniture? Or we discount car parking, perhaps? Are there other incentives that could be made available before you then go to a rent free or discount the rent?
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Now let’s get back into the episode.
Richard: Before we move on to costs, there’s two things I wanted to talk about. The first one was certain items that you’ve observed that renters will pay for, maximising revenue? And then I’m keen to talk, you can let the audience know your story of your favorite staff concierge, I think you said, and just how fantastic she is in terms of engaging people in the building and making them sticky tenants. But before we get onto that story, are there certain line items of the revenue, even if it’s ancillary revenue, for example, car parking, storage, that you can actually maximise revenue, that in your experience, the tenants are prepared to pay for?
Dominic: I mean, it’s worth saying that the demographic and what tenants will or won’t pay for does change from one market to the next. And by chance, in Southampton, we have two assets. So different locations in the city, and the demographic and what they will or won’t pay for is different. But I can say with a general rule of thumb, unlike most UK operators, we do not 100% furnish our properties. Furniture, is a sticky factor. And this is a bit of a US reference point I picked up many years ago, that most of the US market Multi Family is unfurnished.
Richard: Interesting. Okay.
Dominic: If people have to move in with the bed, the sofa, the tables and chairs, it’s a bit of a pain to move out. And so does that mean they will stay longer? There’s a whole stash around meeting friends and making friends as well. But furnishing a building 100% means it’s a lot easier to move out.
Richard: That’s actually very clever. So you’re talking about friction costs where it’s just it’s so difficult. Wow. Okay. Well, that’s great.
Dominic: So, on that basis, what we’ve done is we’ve taken a middle ground. So the UK market’s gone for a 100% furnished approach, and it’s including the rent. Something I picked up from my time at the family office, if people want furniture, they can have it. We’ll furnish beds, sofa, tables, and chairs, maybe bedside table, but we’ll charge for that. Because ideally, we don’t have furniture in the property. It’s a pain to manage when they move out, if things are damaged, I need to replace them, storage. Furniture is a bit of a pain. So the default is we don’t want it. If people do want furniture, can we charge for it? And we furnish quite lightly. There’s no rugs and extra cabinetry. It is ‘keep it simple.’
Richard: All right. Could you please tell the audience your story of your friendly staff or the role that the staff play with attracting and retaining tenants?
Dominic: Yeah. The analogy, and I was saying it to you yesterday, Richard, the GAA has run study tours to the US. And in fact, we’ve started touring our own assets, the assets in the UK too. We were out in California a few years ago, and it was with a different investor that we’re now working with. And we toured two buildings one morning. One was a brand new Multi Family, very shiny, all the bells and whistles. And then thereafter, we went to a property that was a 1950s, low rise build. They were going through a refurbishment program there. So the two properties, you definitely want to move into the brand new, all bells and whistles. The 1950s, whilst the amenities had been refurbished, the apartments still were quite tired. Yet when we arrived at the 1950s property, we were greeted by the property manager, and her team in the lobby waiting for us. Biggest smile. This lady had the most incredible personality. We were all handed out water. We’re all greeted as a team, and just that arrival and the buzz they had was so overwhelming compared to the previous building where that wasn’t the case at all. It was understaffed, automatically looked very stressed, with a bit of a burden. And we’ve used it as a reference point ever since. That if you’re a prospect and you have two options, the brand new building where the staff offer the excitement and the feel was a little bit weaker, versus the other property with this manager. I’ve forgotten her name now, but it was just to reference her. It’d be the latter.
And so, the importance of that site team is so critical. And we have a few of those on our own team, who are absolute gems, and they really help the building tick. They know everyone’s name, birthdays, if there’s a baby born. They just help the building stick together.
And one of the challenges that we’ve found in the UK is hiring great people. There are some people with experience in the residential, block management or even BTR world, but it doesn’t necessarily come with the right attitude. And it’s the attitude piece that’s key. We can train people up on health and safety and compliance, but it’s that ability to engage and have conversations. We bought a property that was about five years old and quite tired. It was rundown. The site team were pretty demoralised. We bought brand uniform to them immediately. The first one is the event that we had, I asked everyone on the team to go engage with the residents, chat to them, we had a survey running. But I vividly recall, it was one of the cleaners who took this with a lot of focus. She was taking people’s phones, getting people to scan the survey code there, and really encouraging people to give their feedback. Some of the others were less engaged. So, find the right people, it’s really important. And paying well. It will all come back on better renewal rates and improve your NOI. Your NOI will get better as a consequence of these individuals.
Richard: Fantastic. Let’s shift gear please and jump into costs. Obviously, the other side of the equation, as you very well described it, is to reduce costs. So, what are some of the ways that you’ve been able to reduce costs? And I suppose what are some of the lessons learned or that could be applied to Australia?
Dominic: Through the hierarchy, I guess, the biggest cost first. So staff. The quantum of the staff you need, leasing up your property, is going to be that much greater than when it’s stabilised. And so, you naturally get staff churn. And when that occurs, do you necessarily not replace those roles? But that’s one area where we’ve been thinking about is our staff count as the property stabilised, not cutting too many corners. And if in doubt in our minds, perhaps another body on that building maintenance. Repairs, maintenance, make sure you’re responsive enough. If you get lots of churn of units during the weaker months, then you just get high void, and your voids are one of your biggest killers on your NOI. So even though it’s a chance to cut certain corners on cost, the impact it might have on your vacancy could be quite telling. So staff is always the area where we first focus.
Building insurance, not that it’s the next biggest cost, but it’s an easy one to talk about. In the UK market at least, insurers are nervous about vacant buildings. And so, the insurance premium that we’re paying or have paid has been that much greater as we lease up the property in that first year. But once it’s stabilised, that insurance cost will come down and has come down. But there is an art in having the right broker, so we’ve switched brokers during our time. And part of their job is to help educate the insurers. And we’ve found in the UK that the insurers sometimes are less familiar with the asset class. You get backed up into traditional blocks of apartments that are buy-to-let, and the risk profile is different. So how good is your broker in helping ensure that the insurers they talk to get it? And so that’s something that we’ve been conscious of over the last few years, and deem to switch brokers accordingly. Part of it is to make sure that all the perils that are insured against, there’s no corners cut in that policy. And for us, that the bank debt that we have against these assets, ensuring that we’ll meet the loan covenants and requirements in those loan docs for insurance too. So it’s a bit involved in that, but there are savings to be had potentially depending on how the market is working.
Another cost is clean management fees. So our staff management fees is next. And there’s always a big debate as to what that rate should be. Less familiar with the regs in Australia, but certainly in the UK, it’s currently ever more regulated. And frankly, it’s a cost to any property manager to run these properties, to adhere with all the compliance. For some investors, it’s let’s cut corners, race to the bottom. If I was in their shoes, I’d be nervous about going to sleep at night. The duty of care that exists, in keeping these buildings safe, that’s something that keeps me awake at night. Are some investors trying to cut management fees too low? This may be music to the managers ear that they can actually push back. I don’t think it’s a healthy place to be. It might look good for the investors if they’ve got their fees a little bit lower, but are they doing a disservice to everyone involved? And indeed, if you’ve got a property manager that is pushing rent hard, they’ll pay for themselves 10 times over. So staffing, management fees.
After that, contract services. We’re going through a centralisation process of cleaning contracts and repairs and maintenance. Its taken a bit of time to get there, and you are reliant on a strong market of repairs, maintenance, landscaping, contractors, pest control. Some companies do it all, perhaps not very well, but some companies will focus, but you get inefficiencies in your costs. So we have five assets now across the Southeast. We’re getting those efficiencies in place. But if I was rounding back to what drives NOI, yes, there’s a cost budget to be focused on. But we’d rather get 1, 2, 3, 4 % on headline rent. In fact, they’ll pay for more staff, get better service, get better attention. It’s quite circular in that way.
Richard: It’s very clever. I can hear as you’re talking through are you balancing revenue versus cost, obviously get to your NOI, and I’d not consider being able to then pay for some of these other items that could then be capitalised into that self-fulfilling or that circular argument.
Can we shift gears again? When we were preparing for this, you made the comments about how you still have a bit of a gripe with how these assets are valued. And I made the comment to you going, we’re really struggling in Australia to value the assets and there’s no criticism of the Valuers, of course. I’m convinced this also happened when student accommodation was emerging and it was a different asset class. But you, in a passing comment when we were preparing, and I picked up on it because I assumed that you guys had all your guidelines perfectly set in stone and it was much more easy because it is very difficult right now and there’s a lot of argument from either the finance or the developers going that the values don’t reflect the true BTR value proposition. So, what are your views on that? How is that emerging?
Dominic: I’ll try and keep it polite and civilised. I used to be a Valuer at the start of my career, commercial real estate. So, I feel like I can talk with some confidence. The UK market, the RICS, how things are valued, the Royal Institute of Chartered Surveyors oversee that universe, and the valuation guidance is colloquially referred to as the red book. For many years, the red book did not include valuation guidance for residential investment. What came to pass about 2012, 2013 at the time of the task force, the industry came together with the RICS to create an information paper on how investment should be valued. I recall seeing that paper, and it still referred to this historic reference, of a breakup value. It had a block for flats. The default at the time was, if you were to break it up, what would be the aggregate of those sales values less any sales costs? And that is your starting point. And the colloquial reference is a discount to the bid condition value. VP is a million quid. A discount might be 10%. Therefore, it’s worth $900,000. And that discount to the bid condition value is a bit of a finger in the air based on investment comps or sales. So, all that trades are at a discount of 15%, so there’s the market. That information paper that had been drafted, that was the cornerstone at that time, thinking rather than looking at the net operating income and modifying that by a cap rate, which is traditional in commercial real estate. In my mind at the time, I remember having a few strong conversations with others that this is an NOI based valuation approach, not a discount to VP. And what’s come to pass is that valuations have been carried out and we’ve been party to for our own investments, you will have a reference to both the vacant possession value and the investment value. Both numbers are being reported. We were finding that the Valuers we were working with or acting on behalf of the bank and the debt, the loans had, they were looking at the income that we’re generating and the NOI and the cap rate and seeing that our investment value was creeping very close to that breakup value. In fact, it was on par. There was no discount. And so, there was a real concern around, well, that doesn’t seem right. Fortunately, that kind of Rubicon, that investment value can be great, that investment value has now been passed for assets, and investment value is greater than VP. And that’s been a little bit of an undertone to the valuation market for some time. But to some extent, it still exists now. And there’s this sense with some Valuers that the default must be breakup. If you’ve got a 20 or 30 unit apartment in a very strong sales market, and this certainly happens in, I think, places like Florida where there’s a strong condo market. Breakup can be greater than investment value. But what you’ve got to take into account is that if you have 150 units, it could take you 18 months to break it up completely. Your profit is only in the last 5-10% of those units. And if the sales market is against you in that time, you lose all your profit. If you have a block of 20 apartments somewhere like Miami or Central London, actually, if we breakup in six months, the sales value is probably pretty high. Breakup might be a reasonable valuation metric or approach. But 200, 300, 400 units where it’s been designed for rent, where the unit mix is way more geared to renters, i.e. small units. All are one bed’s flat out the door, by far the most popular unit type. Two beds to an extent. But breakup building for sale where the unit mix is geared towards Build to Rent more one beds, that’s not attractive for people buying an apartment. So in my mind, I struggle with a focus around VP or discount to VP, where you’ve got these larger blocks.
We’ve got a block of 58 apartments in a small town. In that circumstance, I can understand perhaps reference to VP. The valuation market has been evolving, for the last decade and some. We’re certainly getting there, but those are some of the themes that we’ve had to grapple with.
Richard: Great. Well, there’s at least two developers and they know who they are. I’m going to put them in contact with you because they’ve got a few gripes with exactly what you’ve said. And I’m sure they’d like to talk to you a little bit more and hopefully get some advice if you’ve even done some of the guidelines. And if there are guidelines overseas, maybe we can even put a link to that in the show notes because I don’t know how evolved it is in Australia. I’ve seen bits and pieces, but I think it probably would go a long way to helping the industry derisk and understand the asset class. I’ll make a note and we can put that in the show notes, if that’s all right.
Dom, we’ve got through a lot today. Just before I close off the interview, did you have any other comments you wanted to make in terms of learnings for the emerging Australian market in this space? I suppose the biggest learning through your years of being on the ground.
Dominic: I think there are certainly properties which aren’t perfect. Unit mix, amenity mix. But you’ll lease them up at a price. If you’ve got time, then an energy to redesign a building in a way that is fit for purpose. Small units, great amenity mix, making sure you’ve got good back of house facilities for the staff, that their kitchen isn’t buried in the basement, maybe some natural light for where they eat their food, that would be nice. That it’s something that will come to pass. I remember a touring building just outside Washington, DC that was operated by a company called Bozzuto, a huge presence on the East Coast. And I think they’re probably about six months leased up, but PC had happened, it was quite new. And I was saying, well, tell me about this building, like what has surprised you? And they said that they were convinced the demographic would be 35-40. It turned out to be about 45-50. And the average of our portfolio is 35-40. And so you can get fixated on designs. It’s got to look good, but it will lease up if you’ve already got the right team there, the right strategy. And I think people underestimate how challenging it is to manage these properties, and the coal face of this struggling perhaps to convince investors to pay them the right kind of fee. I feel for them. You need to justify that you’re good at your job, of course, but I think there’s a lot to be learned from the UK. And on a GAA side of the house, the idea of study tours, I mentioned yesterday. It’s a bit of an unashamed plug, but you said it was okay.
Richard: Absolutely.
Dominic: That if people wanted to come to the UK and tour the assets that we have, and they’re quite different shapes and sizes, in different towns. There’s a collective variation of stories as to each asset, and where it’s located. And we’ve done this in the past where it’s a bit of warts and all. We’ll talk about highs and lows, do plenty of lows where tenants are misbehaving, or challenging. That’s certainly one message I gave to the government at the time and still give is that, sure, landlords have a long way to go to improve. At the same time, tenants are not angels. And we’ve got our own storybook. I’m sure others do too. I think one message is the management is critical, getting it right, focus on revenue, and staffing.
Richard: Fantastic. Well, Dom, as I said, we did get through a lot today. That being said, I still feel we’re only scratching the surface. I’m hoping that this episode will get a lot of interest and I’ll be certainly sending a few people your way. And your comments about the study tours, I think are an excellent idea because having yourselves take people through some of the assets and doing the warts and all analysis, I’m a big advocate right now, especially in Australia, helping to derisk the BTR asset class. We have, I know the UK does too, a major housing crisis. BTR has a role to play, a significant role. In fact, looking at where everything is moving. And the sooner that we can get finance fully understanding the asset class, and get building these assets out, it’ll go a long way to helping house Australians and helping affordability. To do that, definitely, I see a lot of values in the study tours.
Dom, let’s say goodbye for today. But again, thank you very much for coming on the show. I’ll post links to the various diagrams that you’ve kindly prepared as well as some of the notes and references that we’ve made today. And just to our listeners, I know a bunch of you have already reached out to David. Please also reach out to Dom. He’s very modest, but certainly when I spoke with David and his colleague Ronak, they said he’s one of the best in terms of knowing about net operating income. So certainly, reach out to him and I hope that you heard today, his experience certainly speaks for itself. So thanks everyone, and thanks, Dominic, for coming on the show again.
Dominic: I appreciate it. My pleasure. Thank you, Richard.
Richard: Hi, everyone. I hope that you enjoyed this show with Dom. I thought it was absolutely fascinating, and I don’t think that there’s any substitute for getting firsthand experience from people that have lived and breathed the running of these assets on the ground. So please certainly reach out to him if you’ve got any queries.
The takeouts, there are a few of them that I wanted to highlight with everyone today. Please take them away and apply them with your investment and development decisions are as follows. I thought it was interesting Dom’s comments about the size of the residential markets in the USA versus the office markets. And you can see, obviously, it’s a much smaller market right now in Australia, but the scope for growth really screams out at me like it certainly did to him years ago. And I think that there’s a significant opportunity for the space to grow and have a very positive impact across Australia. So, hoping that all our government listeners are able to work towards incentivising the market, but also all our developers and investors. Just remember that it’s going to take one to two market cycles for the segment to emerge. But when it does, I think it’ll be a very scalable size of the market.
The second point that I loved Dom making is in terms of maximising your Net Operating Income. You look at both the revenue in terms of increasing the revenue and then also minimising the costs. And I think that listening to him talk about how you can tweak both of these metrics to maximise your Net Operating Income per square foot or per square meter, I think, is really important. And, again, this just comes from on the ground experience. I thought his comments about the lease up rates and leaving money on the table if you lease up too quickly was extremely well made. And, again, that’s just down to first-hand experience because I have had a number of conversations, and they are more academic right now, with whether we should have fast or slower lease up rates. And his comments about having slightly lower lease up rates, but then also, higher weekly rents because it’s very difficult to ratchet up the rents in the future, I thought it was extremely well made.
I loved his comments about the hockey stick take up of leasing activity. And, certainly, I see this in Build to Sell projects where there’s points in Build to Sell projects where sales are very strong. And, certainly, when we study the leasing market, you can see the same thing in Australia, and it is also at the start and into our summer, much like it’s happening overseas. And perhaps that’s the best way of modeling this and, obviously, having on the ground assistance and expenses for those periods of time, conversely, having slower periods and factoring that in.
The final point I thought that was really telling is the concept of furnished and unfurnished apartments. Again, I’m having this debate a lot right now with different developers, and there’s obviously various schools of thought. But Dom’s comments about having unfurnished apartments and those friction costs a pain to move in and move out, and their argument that it can make tenants more sticky makes perfect sense. In my mind, I’d be looking at it the other way going, if you’ve got smaller apartments and people are coming into BTR, it’s very difficult for them to afford to pay for their own furniture of a smaller size and then to be moved in and moved out, and it is a pain. But I’d not considered that maybe they buy it once, and it’s so much easier for that segment of the market to just stay put. I think that’s different schools of thought. So please, again, consider the demographics, the location of your projects, and the proportion of furnished or unfurnished because I think that there’s opportunities for both parts in this. But, again, that friction cost argument, I think, is a very clever one that has been made. Anyway, I hope that you got a lot out of this session and I look forward to talking to you in the next one.
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