N.Z. Commercial Property …Popular Ways to Invest (Part 1)

With continued low bank interest rates there is now a significant gap between the cost of capital (mortgage rates) and the cash return potentially available from commercial property. There are several ways to invest in commercial property, with the most common being the following:

DIY – Go out and buy a building yourself. Some investors like to be able to drive past their own building and have direct control over what happens. There are also the advantages of being able to gear (borrow) against the property, with associated tax benefits and the potential to leverage returns. However, because much of the ‘quality’ property is in the $5M+ price range, this is out of reach for many single investors. At the more affordable ‘sub-$5M’ level, competition appears to be fierce for the few good properties that come up. As such, this seems to be driving down yields, with anecdotal evidence suggesting that the cap rates are now creeping down to around 7% for ‘prime’ buildings in this hotly contested price range.

The Canterbury earthquakes have also significantly reduced the number of quality buildings available. However, perhaps the biggest single issue now is the change in insurance coverage. The Earthquake Commission no longer insures commercial buildings and commercial excesses that were previously 2.5 per cent of the loss incurred may now have risen to 5 per cent of the site value, with those for pre-1935 buildings being even higher. In addition, premiums have increased markedly – up to 350 % for those buildings built before 1935. As such, investors should always address the cost of insurance and the insurability of buildings before committing to purchase. Without insurance cover you will not be able to secure a mortgage, and even if you were able to purchase debt-free, the building may be very difficult to sell in the future if potential purchasers cannot obtain funding.  It is also important to investigate the changes in insurability for tenants. If tenants are unable to secure cost-effective business continuation insurance then this may affect the ‘lease-ability’ and therefore the value of the building. While this does not rule out older buildings as an option, any due diligence should consider the likelihood and cost of earthquake strengthening up to an ‘acceptable’ standard. Because councils and insurers etc. are still coming to grips with the post-earthquake environment, it may sometimes be difficult to get a definitive answer about potential upgrade requirements and costs. The absence of this certainty does increase the risk profile of the investment.

While owning your own commercial building may have some significant benefits, it is important to undertake thorough due diligence that balances the advantages against the potential risks. Particularly in this post GFC (Global Financial Crisis) environment the conventional wisdom is now to “hope for the best but prepare for the worst”. Some investors may also find that other forms of commercial property investment are better suited to their circumstances.

Property Fund – Listed. There is a choice of property funds listed on the NZ Stock Exchange. Each fund typically has several properties, which in theory spreads risk. People invest by buying shares in the fund through a registered Prospectus, in much the same way as they would any other publicly listed company. However, because the share market is typically driven “by fear or greed” the share value can fluctuate quite significantly.  As a result, the share value often bears no relationship to the underlying asset value. For example, in recent years the shares in some of these funds have traded well below the NTA (net tangible asset) value. A major advantage of publicly listed property funds is that the shares can be readily traded at ‘market price’.

Property Fund – Unlisted. These have the same characteristics as listed property funds. However, because the shares are not publicly listed and traded on the share market, their value is generally closely linked to the NTA (net tangible asset) value per share. As such, values tend to be more stable. On the flip side, the shares are not as easily trade-able, although most funds will normally have a ‘secondary market’ to facilitate buying and selling.

Property funds generally pay out their tax-paid profits as dividends. Some property funds are now set up as PIE’s (Portfolio Investment Entity) which may provide tax benefits depending on the investor’s specific tax situation.

In Part 2 next month I will discuss ‘Property Syndicates’ – another increasingly popular form of commercial property investment.