Is John McGrath the new Aussie oracle?

Guest observation

Amid current speculation that John McGrath is looking at listing the reputable McGrath Real Estate Agency brand on the ASX, my mind turns to iconic investment tycoon Warren Buffett, a man referred to as "The Oracle". Buffett has the uncanny way of knowing when to take advantage of market highs and market lows.

It's interesting to take two pages from Buffett's encyclopaedia of successes and compare the premises to McGrath's alleged venture.

The first page, or principle, is Buffett's patience in waiting for markets to turn or bubbles to pop, enveloping vulnerable companies when the moment is right. He likens people's emotional purchases and the high risks taken when markets are overheated to "a virus spreading through a kindergarten".

Can we take Buffett's observation of 2003's mobile-home industry, where credit and purchasing was rampant and out of control, as a mirror of our current property market?

Is there a sign, a possible game changer to the operation of real estate companies, that our own Aussie Oracle sees?

Does McGrath see something that the average punter, property investor, or even real estate agent and property economist has failed to see? If the rumours prove to be true, I would judge  McGrath's move to float the agency (brand), as a bold and strategic consideration, at the present time.

It could also be the a possible ideal exit strategy for current real estate office holders, in a time where a turning property market is imminent. An exit strategy that can well end with a bang.

Another Buffett principle is to "invest in or buy a company that will produce 20% growth year in year out". Buffett refers to this as a "compounding machine".

When we apply Buffett's compounding machine strategy to the nature of the real estate business, in essence, the asset has to be a well-oiled and refined machine to produce high yielding dividends for stakeholders. Will this hold true of the individual agencies/offices that make up the McGrath brand?

Can a real estate brand or, more to the point, an agency with 61 offices, be a sustainable or profitable proposition that can be referred to as a compounding machine (even with growth into the Asian market)? Will the perceived growth in the real estate arena be enough to persuade investors to buy shares should McGrath list on the ASX?

False perceptions

In my view, there is a general and false perception that most real estate agencies are prospering.

The public have formed this belief solely due to high property prices, which are heavily inflated. Nonetheless, people make an association between high property prices and the myth that real estate offices are making it big.

Contrary to people's perceptions, the media is currently reporting that there has been a downturn in property listings.

This therefore means more competition among agents and agencies. As a matter of fact, more real estate offices are navigating towards bankruptcy, let alone being profitable enough to have any close association to this idea of being a "compounding machine".

I strongly believe that many real estate agencies, which are highly reliant and dependent purely on sales-listings, are pushing towards the red zone very quickly, and will soon be out of business. I know of many offices with rent rolls - landlord databases - in which the licensees have not paid themselves for up to a months.

The value of a real estate agency (other than the freehold).

The true value of a real estate agency is in the rent roll, not sales listings nor office fixtures or fittings. Not even the European cars most drive. Anything else outside of a rent roll is a liability, not an asset. Rent rolls are traded, "bought and sold". Some would like to believe that the so-called "databases" of purchasers an agency has, hold some sort of value. On the contrary, the only database of real value is the landlord database.

The current values of rent rolls on the market are reflecting ratios from $3.00 to $4.00 on a dollar income per annum. If the annual rent roll income of an agency was $100,000 per annum, the rent roll would be valued between $300,000 and $400,000,and this would depend on how clean and up to date the property management files are kept.

Would I buy shares in the float?

The main reason I would buy shares, if the McGrath brand was to be publicly listed, would be no different to a land release sale.

I would buy in the initial expression and I would be prepared to sell soon after the hype levelled out along with the price. As they say when buying in a land subdivision, buy in at Stage 1 and sell in Stage 3 and 4 before they release Stage 5. Anyone buying in after Stage 3 runs the very high risk of making no return on their investment, or worse still, going into the red.

I am of the opinion, because of the brand name and the level of respect the general public have of the brand, it may well be a welcomed stock. The public's misconceptions around how an agency is valued will further fuel the price of the shares. Therefore I will definitely buy in, sell soon after, and not buy with the view of keeping the assets long term.

Why I wouldn't buy shares?

It is not a question of why I wouldn't buy the shares; it is more a question of how long I would be prepared to keep them. Shares can take on similar characteristics to current overinflated real estate prices in most capital cities.

After all, shares tank every seven or so years and we have had a good six year run so far in this market.

To understand my short-term plan, allow me to scope the property management operation as a business. To do this, we need to drill down into how a successful office operates and have a better understanding of the need to maintain a profitable rent roll. These observations are not based on the McGrath rent roll operation. The following are general industry observations.

1. Young and inexperienced, underpaid property managers do not add value to the rent roll. Highly trained and skilled property managers and property officers add value.
2. It is an industry that requires a lot of "human attention" and care, as opposed to a manufacturing plant system that is automated with machinery and robots.
3. Although systems and office procedures can minimise the human work load it can never eliminate the need for skilled supervision required to run an efficient property management team.
4. Property management fees are highly competitive and volatile and these range from 4% to 7% from weekly rents collected.
5. The landlord's contractual obligation to an office is only by way of a 30 to 60 day notice. An Exclusive Management Agency Agreement does not mean you own the management in a literal sense.
6. The ratio of a skilled property manager (PM) to property managements (M) is 1PM:250M
7. The return of investment at the mid-range value of a management is three and a half years. It will take three and half years to recover any capital investment made, provided there was no attrition of clients/landlords.
8. Point seven does not take into account cost of overheads to maintain the office open.

Personal experience

Over the last 24 months I have seen rent rolls creep up in value, from $2.75 for every $1 to $4.00 for every $1 earned. When I have inspected property management files to determine whether or not our office would purchase these, they have come very short of the mark. Most have required more money and work to get the files up-to-date and in order, so their asking value was priced at more than they are worth.

We have in the 24 months also bought a rent roll for as little as $1.20 for each dollar of income it generated. This is not a common occurrence, but it does happen.

We have also been offered a rent roll for $2.20 per dollar of income generated. Although it looked like an attractive proposition, it cost more than it was worth. It was a risk not worth taking for the reason previously stated: no guarantee that the expenditure could be realised over the three and a half years and in this case in two and a half. It was just not worth the risk.

Therefore, on the previous figures provided, I have also wondered whether or not current rent rolls are overpriced. Are they also caught in a bubble of their own that could just as well pop?

As previously stated, I would be the first to take up an offer in the McGrath float.

I would not, however, buy in with the view to keep the shares long-term. There aren't enough factors that would make me consider the stock to be one Buffett would label a "compounding machine". I am nonetheless intrigued and keep asking myself:
"Is this the perfect exit strategy for the man and the licensees that make up the brand?"

Again, I make my observations purely based on my understanding of a real estate office model and the perceived value of a rent roll. A share broker would have a complete and better understanding of the actual value or worth of the shares when taking into account other assets not just the rent roll.

EDWIN ALMEIDA is managing partner and licensee-in-charge of Just Think Real Estate.