10 rules of commercial real estate investing
Investing in commercial real estate is not as difficult as it may appear.If you follow the principles of long term investing, you can earn much higher returns than most debt instruments. Keep the following points in mind while investing.
⦁ Location, Location is everything. Commercial properties provide returns through two avenues— rent and capital appreciation. Both are heavily dependent on the location. Look for locations where vacancy is less than 5%. This will mean that supply is in check and tenants are less likely to vacate, leading to higher rents and capital appreciation. A high vacancy location gives tenants options to move and renegotiate rents.
⦁ Quality: B, B+ OR A Two buildings may be in the same location, but the one boasting better quality will always get rented first. It will also attract better quality of tenants. Needless to say it will fetch the investor higher rents, better tenant retention and higher capital appreciation. Multinational tenants are always willing to pay a premium for quality. Look for certifications like LEED gold or platinum ratings or buildings that have nicer looking lobbies, more elevators, higher ceiling heights and better views. Higher quality properties are also more liquid and can be sold much faster.
⦁ Demand vs Supply This is one of the first things a savvy investor has to analyse before committing to buying a commercial property. Every city has different micro-markets. In Bengaluru there is ORR, Whitefield, Electronic City while in Mumbai you have BKC, Nariman Point and Parel, among others. Each micro-market has a stock (amount of office already completed and leased) and upcoming supply. Annual demand is also published regularly by brokers like JLL, Cushman and Knight Frank.
If the annual supply over the next 2- 3 years exceeds historical demand, the rents and prices would come down. A disproportionately high supply will affect both new and old buildings. New buildings will command lower rents as tenants will get more options in the market while tenants in older buildings will renegotiate rents and escalation clauses.
⦁ Market rent vs in-place rent This is a slightly advanced concept that institutional investors use to see how risky the property is. Let’s assume that there are three properties available at more or less the same price but each with a tenant paying different rents.
⦁ Building A has tenant paying Rs 10 and is selling for Rs 100
⦁ Building B has tenant paying Rs 11 and is selling for Rs 105
⦁ Building C has tenant paying Rs 9 and is selling for Rs 95. Which one
would you choose? Many would say Building B as it has the highest rental return (10.5%). However, an intelligent investor will first ask, “What is the rent in the market?” meaning what are new buildings being rented at today.
If the market rent is Rs 9, Building C is the safest investment as the tenant is least likely to vacate the property. Tenant A and B will most likely renegotiate their rents or not pay the escalations when they become due. Another way to look at it is that you are buying an overrented asset at an above market price.
⦁ Quality of tenant A good tenant can significantly increase the value of a commercial property. Looks for bluechip multinational tenants and avoid smaller and unknown companies.
Good tenants pay rents on time, pay higher deposits, stay longer and increase the value of the property.
⦁Interior fitouts As an investor, you should always ask who has done the interior fitouts in the property. When an office is delivered in India, it is provided bare shell (like a garage). The tenant needs to do the flooring, ceiling, air conditioning, wiring and the interior cabins, conference rooms etc. Some tenants like to do their own fitouts while others ask the developer to do it for them for which they pay an additional fitout rent. Fitouts generally cost between Rs 800-1,000 per sq ft and developers charge Rs 25-30 per sq ft per month (Rs 300- 360 per sq ft per year). A tenant who has done his own fitouts is likely to stay longer in order to sufficiently recover the costs.
⦁ Base rents vs fitout rents Developers often dupe investors by showing higher rental returns by including the fitout rent component while hustling them for a higher price. But here’s the catch: fitout rents are not permanent and are payable only for a fixed period (generally five years). So if the base rent is Rs 50 per sq ft and fitout rent is Rs 30 per sq ft, the tenant will pay Rs 80 per sq ft (Rs 960 per sq ft per year). If the normal selling price is Rs 6,000 per sq ft (where the tenant has done his own fitouts), a developer may try to sell the fitted- space for Rs 9,000 per sq ft promising a higher return of 11%. While this may sound enticing, the fitout rents will stop after 5 years dropping the return to 6.7%.
⦁ Lease structure Commercial lease strictures are very different from residential ones. They are structured as 3+3+3 or 5+5+5 meaning 9-year (or 15-year) lease with escalations every 3 years (or 5 years). They are also one-sided. The tenant can vacate at any time whereas the landlord cannot ask them to leave for the lease period. There can also be a lock-in period (generally 3 years) during which the tenant cannot vacate the property. While analysing an investment, the investor has to understand how the lease is structured and the inherent risks involved. In general, the longer the lock-in, the better it is for the investor.
⦁ Security deposits in commercial properties vary between 10 and 12 months’ rent. Be careful when a tenant offers 6 months or less as it means that they could be looking at a short-term option or have cash flow issues. Startups typically tend to ask for smaller deposits and shorter lock-ins.
⦁ Diversification We’ve all heard that diversification reduces risk. This is especially true in commercial real estate. If you invest all your savings in one property, you are exposing yourself to a higher risk. In case the tenant vacates, rents will stop while maintenance payments, property taxes etc will have to be paid. Investing in multiple properties across cities will reduce variance in income by diversifying propertylevel risk.