investing in real estate 1

Investing in Commercial Property – The Ultimate Guide

The following article includes everything you need to know about investing in commercial property. Here we discuss the characteristics of commercial property, factors influencing its performance, different commercial property sectors, and a brief history of the sector.

Characteristics of Commercial Property

The two fundamental characteristics of commercial property are rental income paid by tenants and the value of land and buildings which form the income and capital return components of property returns.

It’s worth noting that return characteristics of residential property differ significantly from an investment in commercial property.

Capital growth vs. Income strategies

Investors may focus more on capital growth or income when investing in commercial property, and certain types of commercial property are purchased primarily for their potential capital appreciation, whilst others are purchased for their ability to generate cashflow (rent) during the term of their ownership.

For example a small country shopping centre with limited population growth might deliver a nice cashflow with little capital growth. In contrast the development of a commercial office building during a boom in the office market may deliver no cashflow but deliver the developer a tidy profit.

Commercial Leases

A commercial lease is a contract between a business owner and a landlord. The lease allows the business owner to use the property to run a business and specifies that the business owner pays the landlord rent.

Different parts of a commercial lease

  • Parties – Who is involved in the lease?
  • Rent Amount – What is the cost of the lease?
  • Start Date – When do payments start?
  • Expenses – What operational costs are included (i.e. utilities, landscaping, etc.)?
  • Maintenance – Who is responsible for maintenance of “common areas”?
  • Improvements – Who pays for improvements to the property to begin operations?

Different types of commercial leases

  • Percentage Lease – Tenant pays rent + percent of monthly sales
  • Net Lease – Tenant pays rent + property tax
  • Double Net Lease – Tenant pays rent + property tax + insurance
  • Triple Net Lease – Tenant pays rent + property tax + insurance + maintenance
  • Fully Serviced Lease (Gross Lease) – Landlord directly pays all costs (usually results in higher rent)

Commercial Property Sectors

When investing in commercial property it is often to think of the three classic sectors of office, retail, and industrial. Within each of these categories substantial variations exist in the size, and quality of particular properties.

investing in commercial property 4

SOURCE: Cromwell Property Group

Retail Sector

The retail sector encapsulates neighbourhood shopping centres, CBD shopping centres, high street retailers, sub regional shopping malls, and regional shopping centres.

The Australian retail sector experienced somewhat of a goldilocks period for the two decades prior to the Credit Crisis. Historically, retail assets have been sought after given the presence of high quality anchor tenants with long leases, which has meant yields on retail have traded below those for office and industrial. Accordingly, through the Credit Crisis, retail capital values proved more resilient.

However, since the Credit Crisis the sector has had to deal with some significant headwinds, most notably higher household savings ratios, high Australian dollar, and the threat of online retailing. While some of these issues have been cyclical there is no denying the structure change undergoing in the sector from online retailing, which has already changed the face of retailing for certain categories.

Owners of retail commercial property have up until now held the upper hand in many lease negotiations as demand has exceeded supply, as shown by the consistent growth in sector occupancy costs. However the sector looks to have turned a corner now and rents are starting to come under pressure. Failure for an improvement in retailer margins will no doubt see downward pressure on rents, although this will be a long drawn out scenario given the contractual nature of rents and the length of anchor tenant leases.

More recently, the entry of Amazon to Australian shores has the market nervous of even weaker retail growth ahead.

Office Sector

The office sector has shown to be reasonably cyclical over time and sensitive to changes in the economy and white colour employment. During these periods office buildings can experience large changes in occupancy and changes in rents.

During the Credit Crisis the office sector was negatively impacted as companies understandably reduced their workforce numbers. This led to a sharp increase in vacancy rates and falls in office rents around 2009. However this was short lived and the significant government stimulus along with rebounding equity markets in 2010 created a mini-resurgence for office space, as prior to the GFC office markets had been incredibly tight with vacancy at record low levels. For a time around 2011 the market anticipate double digit rental growth for the office sector, however that didn’t transpire.

More recently, the combination of a growing presence of tech firms and apartment office conversions have supported the market. These impacts are most pronounced in Sydney and Melbourne, while the Brisbane and Perth markets are still relatively weak, given the effects of a weaker mining sector.

In recent years we have seen the emergence of metro office markets like St Kilda Rd, Sydney Olympic Park, and South Brisbane as an investment alternative. These markets continue to perform well and have benefited from buoyant CBD markets, residential conversion of exiting stock, and the move to co-working employment.

Industrial Sector

The industrial market is interlinked with the broader outlook for the economy and manufacturing. Industrial assets primarily include sheds which are used for distribution or manufacturing, but can also include industrial business parks.

In recent times Industrial assets have appealed to investors, given:

  • higher yields than retail/office;
  • Lower incentives than office, and more stable rental growth than retail.
  • More fixed type leases in a low CPI environment.
  • Flow on demand from residential land prices.
  • Assets being converted into residential plays.

Furthermore industrial distribution assets have benefited from the growth in online retail, with some commentators even referring to these as the ‘new malls’. With the arrival of Amazon in Australia there are expectations that this demand should continue.

The challenge with industrial property is that it’s easy to add supply, and often assets only have one tenant. As a result, investors perceive industrial property as a riskier investment than office or retail property.

Alternative Property Sectors

Over the past decade we have seen the institutionalising of investing in commercial property and emergence of alternative property sectors such as childcare, storage, pubs, and hospitals. This trend reflects the maturing of the commercial property sector, increased awareness of alternative sectors, and the weight of money.

Factors Influencing a Commercial Property Performance

When investing in commercial property it is important to asses its performance. Consideration has to be given to the type of real estate asset (residential, commercial or industrial), where it is located, the quality of the tenants and how much of an investor’s money is in one asset.

It is important to understand that all of the major real estate investment categories generate returns from both income and capital growth.

However, the proportion of that return varies when looking at each asset type.

Valuation Methods

Commercial Property is typically valued using either a capitalisation of income approach or discounted cashflow approach (DCF).

The capitalisation of income approach involves analysing comparable evidence to determine the appropriate yield to be applied to the property under investigation. For example one might find a similar building which delivers a 6.5% yield. The valuer therefore, may choose to apply this yield to the property under investigation by dividing the buildings net income to derive the value of the asset. In most instances the valuer will apply some adjustments to reflect slight differences in the buildings and leases.

The DCF technique requires explicit assumptions, based on evidence, to be made regarding several factors but most importantly the target rate of return (which should cover the opportunity cost of investment capital plus perceived risk) and expected rental income growth. These cashflow assumptions are then discounted back to a present valuer based on the discount rate and timing of the expected cashflow. As expected the DCF approach is a more robust method but more difficult to implement.

Benefits of Commercial Property

Investing in commercial property offers investors a number of benefits, both as a stand-alone investment, and as part of a balanced investment portfolio. These benefits are summarised below.

Cashflow

Commercial property investments typically produce rental income in the order of 6-10% per annum of the purchase price, depending on the type of property, the location of the property, and the quality of the tenant. Under the current interest rate environment, this generally means that even geared property can produce strong positive cashflows, after all interest costs are taken into consideration.

Inflation buffer

Many commercial property leases have clauses which link them to increases in the consumer price index, which means that the income produced from investment in property tends to increase in line with inflation. Although, rents can fall as a result of periodic market reviews or lease expiries, the underlying value of Commercial Property (and consequently, the income that such property produces) tends to increase over time in line with increases in the value of the underlying land and similar increases in construction costs. As a result of all of these factors, the overall trend is for both income and capital value to increase in line with inflation.

Low Volatility

Historically, Commercial Property has provided relatively stable total returns relative to shares.

Commercial property typically provides inflation like capital returns with 6-10% income yields for long periods of time (typically 15 years or so). Then once a cycle, capital returns become very volatile, first turning positive, and then negative. The evidence suggests that these events are either caused by significant moves from under supply to oversupply (like the late 1990’s) or due to credit events, such as the recent Credit Crisis.

Diversification

Many investors understand the benefits of spreading their money over a number of investments, in that if one investment fails or performs badly, it is likely that it will be balanced out by other investments that perform well.

However, when taking into consideration the benefits gained from this form of diversification, you must also take into consideration the relationship between your various investments and types of investments. That is, to gain benefits from diversification, you would ideally like your investments to behave somewhat independently of each other.

Correlation is a measure of how closely movements in one asset class match movements in another. A correlation of one indicates that two investment types perform the same whereas, at the other end of the spectrum a correlation of negative one indicates that the investments move in opposite directions to each other. Historical analysis undertaken by Multiplex Capital in 2006 demonstrated that commercial property performs differently to other asset classes, which is good for overall portfolio diversification.

Tax-sheltering

Under current taxation legislation, investors in commercial property are entitled to claim taxation deductions associated with both the depreciation of fixtures and fittings, as well as taxation allowances representing a percentage of the ‘base building’ (i.e. the structural parts of the building – walls, floors, windows, etc). These deductions reduce the level of assessable income to investors, which means that in general, they pay less income tax than they would have without the benefit of deductions. This in turn enhances the level of their after-tax cashflow from the investment.

By claiming these deductions and allowances, the investor generally increases their future liability for capital gains tax when and if they sell or otherwise realise their commercial property investment, however under current taxation legislation, many investors gain an effective discount on their rate of capital gains tax. The combination of a deferral of taxation liability, and a potential reduction in tax rate, generally enhance the attractiveness of commercial property as an investment.

Risks Specific to Commercial Property

When investing in commercial property, there are a number of risks to consider. Real estate returns may be affected by factors such as investor demand for assets, demand by tenants for commercial space, rental income levels and the supply of new commercial space. The cost of real estate debt, or costs and losses associated with natural disasters or other events which prevent the normal operation of real estate investments, also have an impact on the performance of real estate returns. The following risks are among those investors should consider when investing in real estate:

Sector risk

There are a number of factors which may affect the real estate sector, including the cyclical nature of real estate values, over-development and increased competition, increases in real estate taxes and operating expenses, demographic trends and variations in rental income. Changes in the appeal of properties to tenants, increases in interest rates, the level of gearing in the real estate market and other real estate capital market influences can also affect the performance of the sector.

Vacancy risk

The risk of a tenant vacating a property, failing to meet their rental obligations or failing to renew a lease can have a detrimental impact on rental returns.

Value risk

Asset values are influenced by location, supply and demand, rental agreements, occupancy levels, obsolescence, tenant covenants, environmental issues and government or planning regulations. Changes to these drivers may affect the end value of the asset.

A good approach for those wishing to minimise risk is to invest in real estate which is leased to good quality corporate type tenants. In selecting assets, generally the higher the quality of the asset, the higher the quality of the tenant. Therefore, it is advisable to look for well-located properties, in locations such as central business districts or central shopping malls, with lengthy and secure income streams.

Understanding Commercial Property Cycles

Historical data on investing in commercial property suggests total returns comprise high levels of income, relative to other asset classes, and inflation like capital growth over long periods of time.  Then, at the end of each cycle, capital returns become very volatile, first turning positive, and then negative. The evidence suggests that these events are either caused by significant moves from under supply to oversupply (like the late 1990’s) or due to credit events, such as the recent Credit Crisis. One road sign to look out for is when property yields fall below interest rates, as they did just before the last down turn.

The The Property Council/MSCI Investment Performance Index, shown below, has been established for over 30 years and is Australia’s leading and most credible direct property index.

investing in commercial property 2

The 2008 Commercial Property crash

The 2008 downturn was caused by adverse credit conditions as opposed to property fundamentals. There is a common view that the widespread deregulation of the 1980s has the capacity to provide greater cyclicality to property cycles owing to a greater variety of debt instruments and funding now available.

In fact, in the years leading up to the Credit Crisis underlying global commercial property fundamentals had been relatively strong when compared to previous downturns. Vacancy rates across office markets had been relatively low, rental growth had been strong, and speculative development had been limited. The following table compares the 2008 statistics for the Australian commercial market relative to the previous downturn in the late 80’s early 90s.

Negative yield spreads

The fall out in the sub-prime market had severe effects on commercial property. A lack of liquidity caused an increase in the cost of debt, both in terms of the lending rates and lending margins. The following chart shows the three relevant interest rates for commercial property, all of which increased substantially leading up to 2008.

As a result this caused a situation where property yields actually became lower than interest rates. The only other occasion where this occurred in Australia was during the late 80’s early 90’s, which also coincided with a downturn in commercial property.

The 1990’s Commercial Property crash

Financial deregulation had a profound effect on the Australian economy. This led to a significant increase in demand for office space by multi-national investment companies wanting to setup operations in Australia, in particular the CBD areas of Melbourne and Sydney. This resulted in falling vacancies, rising rents and increases in property prices. In response to this demand a construction boom in commercial property emerged. The table below highlights the increase in office supply over the period.

The impact of the stock market crash in 1987 led many investors to seek investment in the safe haven of property. In addition the response by the Reserve Bank by lowering interest rates meant cheaper debt for property investments, which in turn, induced managers operating property portfolios to gear more. During this time returns from commercial property were very strong, fueled by high demand and low supply.

What started as a very positive environment for property investors quickly changed. Firstly, interest rates at the end of the 1980s increased sharply with short-term rates reaching 18% in 1989, dramatically increasing the cost of debt thereby dampening demand. Secondly, the effects of a continued construction boom started to take its toll with supply outstripping demand leading eventually to chronic oversupply. Thirdly, Australia went into recession in late 1990. The impact of these events eventually sent property prices tumbling down. As a result it took an entire decade to rid the market of the excess supply built up in the early 1990s.

To some extent these problems were exacerbated by elements particular to property such as the illiquidity of property and less transparent valuation methods, both of which are still relevant today.

Longer-term Commercial Property Cycles

Further evidence of commercial property cycles can be gain from the US.

According to the National Association of Real Estate Investment Trusts (NAREIT), REITs underwent three major downturns prior to 2008, each lasting 14 to 27 months. REIT indexes fell 37 percent from September 1972 to December 1974, 24 percent from August 1988 to October 1990, and 24 percent from December 1997 to November 1999. However apart from the real estate depression in 1989-1990, which had similar implications to that in Australia, none of these negative return periods for REITs saw corresponding downturns in commercial property. An example of this is 1997-99 REIT downturn which was driven by the demise of the dot.com boom. In these instances this can be explained by the high correlation levels of REITs with the broader share market.

Evidence from last century suggests that there was only one other period of negative total returns for national real estate-the late 1920s and early 1930s. The evidence suggests that negative returns were caused by excessive levels of new construction, induced by an unusual rise in net operating income (NOI), which in turn was the result of an inflation spike in the general level of prices, which is therefore not dissimilar from our modern experience in the late 80’s early 90’s.

Evidence from even earlier periods suggests a periodicity for such real estate boom/busts of some fifty to sixty years.

Find out more…

For more information on investing in commercial property and property funds and to find the latest offerings visit REAL Property Funds.

Leave a Reply

Leave a Reply

Your email address will not be published. Required fields are marked *