The financial world has been turned on its head as a result of the world economic crisis. Probably more than ever before in history, it pays to be diligent and prudent in financial and legal investigation of businesses being purchased. No doubt financiers are being more diligent in their pre-finance approval investigations, considerations and risk analysis.
Even though management rights have historically had a very low rate of failure, there is no guarantee that that will continue. New issues arising like the economic downturn, expediential increase in competition over the years of the Australian economic, mining and building boom, current decreasing tourism particularly from overseas, reduced consumer spending dollars and corresponding drop in tourism yield to name but a few, have arisen and may affect the profitability of management rights businesses, particularly in the short term.
Sounds all doom and gloom. Not so. Management rights is an established and vibrant industry with a rosy future. It merely points to the fact that in the current climate, it makes good sense to go that extra yard in due diligence investigation.
Contractual Issues
When buying existing management rights, buyers will ordinarily be required to enter into 2 contracts (Queensland only):
1. An REIQ Unit Contract; and
2. An REIQ Management Rights Contract.
The former is typical of contracts used in Queensland for the purchase of units in strata complexes.
The Management rights contract is developed specifically for the industry in Queensland and is widely used and accepted by experienced management rights lawyers.
Both contracts usually contain special conditions tailored to the management rights industry, significantly dealing with due diligence investigations and GST issues.
Both contracts contain typical finance clauses making them conditional upon finance approval in terms satisfactory to the buyer. The contracts usually provide for finance approval within either 21 or 28 days from the contract date. Sufficient time must always be allowed for the financier to process the application and the buyer should seek guidance from their financiers on what is a suitable time frame.
Financiers will not normally approve a loan application until such time as both financial and legal due diligence investigations are completed and are satisfactory. On many loans, particularly loans of larger sums, a financier may require as a condition to its loan approval, that a further legal due diligence investigation be carried out by the financiers own legal advisors.
Financial and legal due diligence investigations, will as a rule, only be accepted by a financier if the parties conducting them, that is the accountant and lawyer, are known to the financier and accepted as experienced management rights professional advisors. That said, it makes good sense that buyers of management rights only use experienced management rights professionals.
The management rights contract contains a condition allowing the purchaser the right to verify the net operating profit of the business. It is worth considering the limiting wording of the relevant condition.
The condition uses the following terms:
- according to normal accounting principals
- nett operating profit calculated by deducting from the gross income of the Business …… the actual expenses of operating the Business
- excluding depreciation GST, borrowing expenses, interest on borrowings and payment for labour related to work which would normally be performed by a two person resident management team.
An accountant experienced in the operation of management rights will know what income and expenses fall within those terms and what is usual for a managed complex. Buyers may do themselves a disservice to use accountants not familiar with management rights who do not have the requisite experience.
By way of comment, what the contract does not apply, is provision for a review of past years performances and whether the income and expenses are likely to remain constant. That may mean a due diligence analysis of things like advertising, expenditure of advertising levies collected, occupancy rates, condition of rooms and fittings, age and condition of building, indication of willingness of body corporate to spend moneys on upkeep of complex and facilities and other things crucial to the maintenance of the business income.
At the end of the day, the buyer should be trying to ascertain that the business is and will remain profitable, able to service anticipated borrowings and to provide profit, benefit or return to justify the work, efforts and investment of the buyer.
Lending Margins
Over recent years there has been a trend from lenders to encourage an increase of lending margins. One can only assume that this was to gain or sustain market share. Maybe its time to question the wisdom of that policy. Maybe the traditional lending margins were developed after careful and prudent considerations.
It is also arguable that historically, buyers may have relied to much on bank loan approval as a due diligence of a deal, rather than the buyers themselves undertaking thorough and conclusive due diligence investigations. In the end, the buyer is the responsible entity.
Experienced management rights lenders will provide borrowers with a list of considerations to assist borrowers in their purchase due diligence investigations. There are only a few banks who fully understand and have the experience to assist borrowers buying management rights. Buyers would be well advised to use one of the appropriately experienced banks as they will be of great assistance in that process.
Legal Due Diligence
A management rights contract properly drawn will provide the buyer and his solicitor opportunity to conduct a thorough, and often painstaking investigation of the contractual aspects of the management rights business which should involve consideration of things like consideration of the conditions of the service contracts constituting the business, the body corporate constitutional documents like the by-laws, body corporate issues including building faults and body corporate harmony, disputes or potential disputes between the committee or body corporate and the caretaker, indication of recalcitrant/troublesome owners or committee members, licensing and letting authorities, all of which are critical to the viability of the business.
Buyers would be well advised to use lawyers suitably experienced in management rights law. Don’t be afraid to ask the lawyer how many management rights transactions the responsible lawyer has undertaken and how many he has done recently. If the answer does not demonstrate a wide experience in the industry with many transactions handled and with recent involvement in the industry, one questions whether the lawyer is suitably qualified to undertake such work. There are many qualified and experienced lawyers available throughout Queensland to assist.
Managers / Caretakers Duties & Remuneration
Buyers would be well advised to closely read and the list or duties that they will be required to undertake as managers and caretakers and to examine the remuneration payable for such duties having regard to the complexity of the duties and time spent performing them. Bodies corporate are often unprepared to consider the fairness or otherwise of remuneration and are always reluctant to increase it. Why? It costs each lot owner money to do so. Members of bodies corporate seldom sufficiently removed and have the foresight to recognise that fair remuneration is critical to performance of duties. Dispute in this area is ever increasing.
Traditionally remunerations have been set on a formula of dollars per lot in the scheme rather than considering the duties and time issues. Lets hope that more science will be used in future in setting remunerations.
Lastly on this subject, caretaking agreements containing regular interval (say 3 or 5 yearly) market reviews of remuneration are in this writers opinion beneficial and preferred over the traditional annual CPI increase.
Body Corporate Consent
One of the last matters to occur in the management rights conveyance is obtaining the consent of the body corporate to transfer the service contracts from the seller to the buyer, even though the consent is critical to the transaction.
Neither the financier nor buyer’s lawyer would consider allowing settlement to occur until the written and executed consent is in hand.
One of the regular grievances of buyers is providing detail of their financial standing to the body corporate. However, whether or not buyers are concerned that requests for financial information by body corporate committees may be an invasion of privacy, most service contracts and also the Body Corporate and Community Management Act make provision for such enquiry. However, there is no reason buyers cannot request that the use of such information be strictly monitored and controlled.
Buyers should also understand that the later the assignment processes commence, the later the consent will be granted and this may impact on the timely issue of the restricted letting agent’s licence. Therefore, the early preparation and supply by the buyer of their required reference material to the body corporate, the earlier that the body corporate can deal with the consent.
Summary
When you have committed to enter the industry by buying management rights, talk to experienced industry professionals at your earliest opportunity. Pre purchaser planning and organisation, and prudent and thorough post contract investigation will go a long way in causing entry into management rights less stressful and secure a bright future.
Kim Christie
Partner
Griffiths Parry Lawyers
Caloundra