Does Size Matter and Other Pressing Questions?
In spite of the opinion of the managing director let’s get straight to the answer… definitely not!
Of course, as in life, size is all about relativity. Stay with me. In the mining industry the bigger the tip-truck the better. In computing the smallest micro processing chip is the most valuable. All depends on application. You can see this is an argument I’ve spent some time perfecting. Draw your own conclusions.
So, what about management rights? I had a really interesting discussion recently with a mate of mine who also happens to be one of the most well regarded accountants in the industry. He and I don’t necessarily have the same view of the value and viability of smaller management rights businesses and, frankly, he was actually more positive than I was. Yes, a positive accountant looking for the upside in a proposition, who’d have thought?
Anyway, the discussion got me thinking and challenging my own views on smaller rights businesses. I’m not sure that my general outlook has changed but perhaps a different way of looking at sub $100K net profit management rights is required.
First, some fundamental mathematics is required. Most banks will lend, give or take a few bucks, 70% of the combined value of the management rights and associated manager’s unit. This gearing ratio will change dependant on geographic location, legislative environment and so on but it’s the general rule for most rights deals. We also need to consider debt service ratios and return on investment. The industry average return on investment is around 14% on the combined value of the rights and unit. Some people will argue that the ROI should only be calculated on the rights value as this is the asset that generates the income. Not true. If an obligation exists to own the unit in order to operate the rights and the exclusive right to operate a letting business vests with the unit ownership then the total capital employed to control the cash flow must be taken into consideration when calculating ROI. Of course, if no obligation to own a unit or reside on site exists then ROI can quite rightly be calculated on just the rights value.
Now, let’s say a punter is looking to purchase a management rights for $250,000 on a net profit of $75,000, 15 year agreements and a unit value of $550,000. These are real numbers by the way and reflect quite a few listings currently on the market. That’s a return on investment of 9.38% driven by the out of kilter ratio of unit to rights value. A nice ratio is 60:40 in favour of the business value, here we are 70:30 in favour of the unit value. Thus, the non -income producing part of the deal is top heavy value wise and that drags down the ROI. Take the unit out of the equation and the ROI improves to 30%. By no great coincidence that’s the market average ROI for a motel lease.
Our purchaser, via his friendly finance broker (that’s me), now goes to the bank. On an $800,000 purchase price and 30% deposit we need a loan of $560,000 at 70% gearing. Unfortunately we also have to demonstrate debt servicing capacity on a net profit of $75,000. That’s net profit for sale purposes, by the way, no tax, no living expenses and add backs added back in. The bank will look at sensitised debt servicing taking into consideration the current life of the cash flow (15 years), capacity to pay principle and interest and capacity to sustain repayments should interest rates increase.
Using these tests most lenders would be hard pressed to gear this transaction at anything more than 50% unless there is other external income to service the debt. My clients now need 50% deposit which they may or may not have. If they do their maximum purchasing capacity is $1.3 million which means they can live in the same style of $550,000 unit attached to a $750,000 management rights that should be making at least $175,000 per annum NP. The question has be asked, why the hell would anyone with $400,000 buy the smaller management rights business? The answer is – they wouldn’t. These smaller rights simply don’t work at 70% gearing with no external income and the obligation to own the unit attached. Where they do work is for a couple with one partner working outside the business or for people who simply want an income stream attached to their home as opposed to a full on business venture.
My concern is that when people buy these small rights they do so because their circumstances suit the situation. That’s fine as long as they realise that they need to find someone in the same circumstances when they go to sell. Either that or have the agreements changed to sever the unit from the business but that’s a separate issue all together.
In most circumstances attaching a small cash flow to a passive, non-income producing purchase simply doesn’t measure up. In management rights, as sadly in life, size does matter.
Mike Phipps
Phipps Finance
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