How to buy a business in the commercial property industry

Buying a property business can be a good way to indirectly invest in property. The fortunes of property companies often follow the market itself quite closely, so returns could be quite volatile. However, a well-managed property company can deliver good sustainable returns.

Many investors believe that the commercial market has bottomed out with prices 50% off their 2008 peak. In the last few months, there has been a rebound in values of some 10%, but there are concerns that this will not continue.

There are four types of businesses that are involved in the property industry: property investment companies; property developers; property traders; and property consultancies.

Property investment companies
These businesses are often owned by very wealthy individuals or families and are not often bought and sold as whole entities. One example of a property investment business is AMSprop Estates Ltd - one of several property companies owned by Alan Sugar, which has around £42m worth of assets. These businesses are looking at long-term returns on property so a well-managed portfolio is essential to ensure long-term success. Many large property investment companies such as Land Securities or Brixton Estates plc are listed on the Stock Exchange and own huge commercial assets like shopping centres or large City-based office blocks.

Property Developers
The property developer's main business model is to buy land, pay someone to build on it, sell it on at a profit, and then start the process again. These businesses might also buy up outdated buildings to refurbish them with the aim of bringing a modern building to market and turning a profit. Large property development companies are often offshoots of building companies as it makes commercial sense to combine the two. There are many smaller property developers that tend to specialise in particular types such as offices, residential, industrial and/or are only active in a particular region.

Property Traders
Due to the illiquid nature of property, these types of businesses are relatively rare and are not particularly tax-efficient as short-term speculation is not taxed as favourably as holding assets for the long-term. However, all property investment firms will need to buy and sell properties to some degree in order to balance their portfolios for optimum returns.

Property consultancies
Property consultancies advise corporate firms on how to make the best use of their property assets, whether they own property or just rent it. They can also advise property investors and developers on all aspects of commercial property including financing and valuations. These consultancies have been traditionally called surveyors and there are thousands of these ranging from the small three-person partnerships to large consultancies such as Jones Lang Lasalle, which operates worldwide with thousands of employees.

Buying a property developer
Property developing is highly dependent on debt due to the large capital requirements to see a project through to completion. Therefore, it is essential that an accurate picture is obtained of the value of projects in progress or completed, and what any likely costs are going to be. Traditionally property developers work on a 25% gross profit margin on a development. The value of a completed building will be based on a multiple of the likely rent received. On prime commercial property multiples of 14-17 are being achieved, representing a 6-7% yield.

It would also be an essential part of any due diligence to look very closely at the funding terms of the loans. Developers often need to have multiple sources of funding so that the risk is spread out between lenders. Another way that developers share risk is by going into joint ventures (JV) with other developers, so again the terms of any JV arrangements must be scrutinised closely.

Any construction contracts will need to be looked at, and the question asked: does the developer have a good relationship with the builders that they use?

Many developers will hold a 'land bank' that they can develop on when market conditions are right or resources available. The current valuations of this land will need to be up to date. The value of land for development is usually determined by the prices paid for comparable land. This will be based on the Gross Development Value (GDV) or the value of the of the completed project less the costs of development.

The track record of any developer will be the ultimate test of whether the business is a good proposition. Have the developments in the past been a success in terms of profitability? Have they been able to sell the properties quickly and at a good price? If they are let to tenants, is the return on investment at or above the current rates? Does the developer have a good relationship with the planning departments of the councils that ultimately give permission for the developments to go ahead? How easily do they find land? Good developers will be offered quality land on a regular basis.

Due to the nature of property developing, if you are looking for a smooth profitability profile then look elsewhere as profits can be stellar one year and terrible the next. This may simply be due to timing of the developments, market conditions, or both.

Buying a property investment company
This type of company looks at long-term returns from property. Returns and profits should be more stable as they are likely to have a steady income from rents. However, as property investment companies are effectively landlords, they do have commitments to maintain properties irrespective of whether they are receiving rent. A property investment business that can show high profits and returns but appears to have run-down properties, is likely to be hit hard at some time in the future. The costs of putting right poor maintenance, rises exponentially over time. The value of any property investment business will be determined by the value of their portfolio, which will need to be professionally determined. On the whole, the cost of management is reflected in the property value.

Active management of a portfolio is essential to get the best returns. Good active management would involve, for example, the renegotiation of lease agreements, making unused space income-generating, modernising buildings, selling poor performing buildings, and managing rent arrears. Much of the advice on this may be outsourced to surveyors, so it needs to be established as to whether this work is being done effectively and, if so, at what price. If not then, as with all businesses, robust management systems will need to be in place to ensure profitability. In essence, the value of an investment company will be closely aligned to the value of its portfolio so up to date valuations will be needed. In practice, these sorts of businesses can have very complex legal structures and tax affairs and if the owners wish to exit they tend to sell individual properties or portfolios rather than sell the whole business. Larger property investment companies are floated on the stock market and are subject to M&A pressures like any other business.

Buying a property consultancy business
These types of businesses are much more frequently bought and sold as the income is generated from client's fees. However, as much of the work is dependent on advising developers, investment companies, and buying and selling property for commissions, they are to some extent dependent on the fortunes of the property market. Much of the relevant factors that influence the value of these businesses can be found in our article 'Grow and sell a consultancy business', published in January. The value of the goodwill of these business is much like any other with multiples of profit being the principal method of valuation. Smaller businesses will sell for around 3-4 times their adjusted net profit with larger businesses nearer 10 times.

Carrying out diverse types of contracts is essential here, as they need to be able to fall back on "bread and butter" work like property management, business rates appeals and lease renewals when commission fees are thin on the ground.

As far as the market in property businesses goes, at the moment, it is a familiar story. Mike Prew head of Real Estate (Europe) at Nomura International said, "Many companies are continuing to hold off selling in the hope of achieving a better valuation. This is having a knock on affect on the availability of M&A opportunities meaning those that do exist, are more likely to get snapped up.

So how do you go about finding these businesses and making an approach? The property industry is very much a networking business and talking and drinking a lot with people in the business is how many of these deals are done. The big annual event is the MIPIM conference in Cannes that has just finished, so book in for next year!

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