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How much is that commercial property worth…to you?

26 October, 2011

I often field calls from clients considering investing in a commercial building. In times when bank deposit rates are low and other markets are volatile, a good commercial building can provide a reliable long-term cash flow, together with inflation proofing capital growth potential and the security of bricks and mortar. However, there are traps for the unwary and as such it is important to do your homework – especially in today’s turbulent markets. This article will consider some of the key things a prospective commercial real estate (CRE) investor should consider.

Your own position – what type of commercial real estate investment suits? Every investor has their own specific circumstances and what is a great investment for one investor may be less than ideal for another. It is important to be objective in this respective.

Financials  – the numbers talk! Many investors rely too much on the capitalisation rate (‘cap rate’) which is the rate of return on the property. A cap rate for the property being evaluated provides the benchmark comparison to other similar properties. The market says that “given this type of property, in this area, at this point in time, what return is considered realistic?

Example: Assume that I have a property that cost $2,000,000. The net rental is currently $130,000 – a 6.5% return. Other similar properties in the same market are currently selling for approximately 6.5% return. Hence, 6.5% is the current ‘cap rate’ – the rate that investors are generally prepared to accept for this type of property. I soon find that it is possible to increase the net rental to $160,000 –an 8.0% return on my original purchase price. However, because the market will still accept 6.5% return for this ‘type’ of property, the value of my property increases to $2,461,538 – an increase of over $461,000 or 23% on my original investment. This can also work in reverse where for example, in a market of high inflation, the required return (cap rate) may increase. Let’s say the prevailing cap rate increased to 9%, the value of my building, despite a hefty rent increase to $160,000, would now be approximately $1.78M, a drop of $220,000 on my original purchase price!

While a cap rate is a simple comparison point, it is only as reliable as the assumed cash flows behind it.

Most institutional investors run a DCF (discounted cash flow) analysis over their projected holding period to arrive at a Present Value (PV). The PV of these cash flows is influenced by the quality and continuity of the cash flows. The IRR (internal rate of return) is also a useful complementary measure. Ensure that, as part of any analysis, you are comfortable with the underlying assumptions, such as vacancy period, maintenance costs, capital growth rate etc.  You should also obtain a valuation report, which would normally be required as a matter of course if you were seeking finance.

The Lease/s – How tight are the leases, how many years to expiry, what are the rights of renewal and how do they compare to current and expected market conditions? Are rental increases attached to CPI? Are they ratcheted (i.e. can go up but not down). Does the tenant pay all the outgoings? Renegotiating leases on turnover may make or break your investment. Consider a nice building with 5 years remaining on the lease to a relatively creditworthy tenant. One of three things will happen at the end of the lease:

  1. Demand for the property type at this location will have increased to the point where new buildings are being constructed and market rents will reflect replacement cost and then current cap rates. You should be in a strong position to negotiate a good rent increase.
  2. Demand will have remained constant and rents will be sluggish. Above market leases will not be renewed without concessions. Below market leases will be renewed at increased rentals or new tenants found.
  3. Demand will have decreased and competition will be severe. Rents may sink to the point where owners mothball or abandon buildings.

The tenant/s – How many tenants are there? Are there one or two ‘anchor’ tenants? How reputable and financially secure are they?  Are they in a growth industry? Are they a national / multinational business with a strong reputation? Is any ‘downsizing’ likely (e.g. government departments)? I suggest meeting with the tenants if at all possible, and understand their future plans and requirements. The tenants may be able to give you some ‘inside knowledge’ on the building and any potential issues. It is important also to note that lease guarantees provided by tenants are generally worthless. If a tenant goes into liquidation, then you will normally be well down the queue of creditors. As such, the ideal is a ‘substantial’ tenant/s in a profitable industry.

The Building and the Site. A LIM (Land Information Memorandum – New Zealand only) obtained from your local council can be very useful in helping to identify issues on the site and/or any potential development restrictions.  Local bodies in other countries should have their own form of a ‘LIM’ that contains records relating to the property.

You should also do a thorough inspection of the property yourself. Become familiar with the site and the neighbourhood. You may even be able to access the records of the building manager (if any) to show if there have been any ‘abnormal’ items arise.  There are ‘A buildings’, ‘B buildings’ and ‘C buildings’, and then there are really cheaply built buildings.

Be particularly wary of older buildings, especially given the current issues (particularly here in some parts of New Zealand) surrounding earthquake proofing and insurability. The last thing you need is to discover 2 years later that you have to retrofit stabilising beams and/or be faced with massive insurance increases. Consider also the implications for tenants in obtaining business continuation insurance. A building without a tenant is not worth much! In most cases a building inspection report will be a critical part of your due diligence. 

Consider also the type of building. If it has been ‘purpose built’ then how easy would it be to find new tenants in the future? Or, is it a multi-purpose building that will readily attract new tenants or may be easily modified for a range of different needs e.g. smaller office spaces. Try to target buildings that are ‘future-proof’.

If this all sounds a bit too much then you may be better off considering investing in a reputable syndicated commercial investment/s, where this due diligence would normally have been taken care of, management is in place and you can spread your risk across a number of different buildings.

Feel free to contact us if you’d like to find out more about investing in New Zealand property. 

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