What price? Searching for value
In our business we spend a lot of time with new clients as they go through the journey of discovery leading up to the decision to purchase an accommodation business.
That process can take weeks, months and sometimes years. Because we don’t charge fees to clients, we certainly hope that one day they borrow some money and we make a few dollars. However, we have a duty of care to put the clients’ interests first and if that means helping them to not make a bad decision then so be it.
At some point in our work with new clients, a suitable asset will be identified and the client, having been pre-qualified at that price point, will ask the dreaded question, ‘What do you reckon it’s worth?’ Far be it from us to tell someone what they should pay for something and frankly we never do. However, we can arm our clients with skills and knowledge to help them make an informed decision when negotiating and making an offer.
Accommodation assets are sold on a yield or multiple calculation predicated on a historical profit-and-loss statement. The first consideration on likely price has to be market averages and yields for that asset class as applied to the particular listing. We have significant market sales data, which can be used as a first test of likely price. Obviously, within asset classes different yields and multiples apply depending on the specifics of the property being assessed. I am still surprised by the number of enquiries we get asking what the multiple is. Not for any specific listing but for the whole market. This is a bit like asking the housing price without specifying the number of bedrooms, property type or location.
Once a general idea of the current market for the specific property is known, we drill down to the more specific drivers of value. For management rights that’s typically the business type, balance term of the agreements, letting pool composition, body corporate relationship and physical location of the property. For motels and caravan parks, many of the same metrics apply, albeit the state of repair of the property tends to figure in these considerations as well.
One of the key drivers of value is the potential ongoing trading performance of the business. In my view, this is a very important consideration and certainly one being looked at very closely by the banks. Sometimes too much emphasis is placed on historical trading and not enough on what the future holds. In assessing the opportunities and risks associated with trading performance, the first consideration is obviously the validity and sustainability of the profit-and-loss statement on which the business is being marketed. There is certainly an understandable propensity for vendors to put forward a profit-and-loss with the highest possible net profit. That’s what I would do if I were a vendor. However, some of the reports I have seen tabled by vendors are simply farcical and don’t stand up to even a cursory review. In particular, allowances for labour costs need to be examined closely and vendors need to be able to substantiate allowances and explain how the business is operated within the cost structure as reflected in the profit-and-loss. Remember, when it’s time to sell, you need to be able to at least get your money back and hopefully make capital gain. Buying on an unrealistic profit-and-loss will make that challenge all the more difficult. For what it’s worth, I’d pay more for a business with a realistic profit-and-loss and good prospects of sustaining that profit.
We suggest to our clients that sustainable future earnings are the real focus point when formulating an offer. Think about what’s happening in the local and broader economy. Look at current competition and what might pop up over the medium term. Is an oversupply of stock on the horizon? What might that do to occupancies and tariffs. If you are going to pay a bit over the odds, we suggest that there needs to be upside opportunity in the business. Paying a premium for a building that’s performing as well as it’s ever likely to, leaves a buyer with only down-side risk. That’s ok if you are happy to simply operate the business and make a profit. If you want to build value, perhaps better to acquire an underperforming asset at the right price and build-up the business. Certainly, if you look at off-plan management rights in this way then maybe that’s where the best upside opportunities are to be found. I am not saying that off-plan is underperforming for, in fact, these business are not performing at all at the time of contract. Get the price right and it’s potentially all up-side from day one.
Ultimately, making a purchase offer comes down to choice. Everyone has different priorities and there is no single decision process that’s right for everyone. However, no-one likes to lose money and sometimes you make your capital gain when you buy, you just have to wait a few years and work hard.
And now, a word on return on equity. When you buy a business, you put in some money and the bank puts in some money. Think about your total purchase spend, including costs, take off your bank loan and the balance is your equity. Now, look at your sustainable net profit, take off bank interest and any expenses absent from the profit-and-loss, take off what you think your labour is worth and the result is your return on equity. Work that as a percentage and think about what else your money could be doing to generate that return. My guess is that you will be hard-pressed to find a better return at this risk level.
Lastly, banks lend on purchase price or valuation, whichever is the lesser. If a buyer makes an offer above market they can still only borrow at bank value. This will result in the need for a higher cash contribution and a fall in return on equity. It’s called the miracle of leverage. Works great in a low interest rate economy, not so much if rates go through the roof.
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