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What is Commercial Real Estate - why you should or should not invest?

Discussion in 'Commercial Property' started by Chilliblue, 15th Jul, 2015.

  1. Chilliblue

    Chilliblue Well-Known Member

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    I am posting some basic information that I hope will be of some use in order to get more activity in this section of Property Chat.

    Please note that the information supplied is as a basic guide only and you should always undertake your own inquiries as to the accuracy of the information supplied.

    Please feel free to post any feedback on your experiences or any comments that you have.


    What is Commercial Real Estate?

    Commercial real estate is property that is generally used for business activities. Whilst commercial real estate covers a broad spectrum, it generally falls into 3 sectors;
    - retail,
    - industrial, and
    - office

    Examples are office spaces, retail shops and shopping centre’s, hotels, farms, industrial warehouses and estates and sometimes vacant land.


    Why Invest in Commercial Real Estate?

    Whilst there are similarities to residential real estate, there are several reasons to invest in commercial real estate. In no particular order:

    Diversification of property portfolio

    Many property investors choose to remain with residential property as they believe that it is a tried and true vehicle to wealth creation. However commercial real estate can offer an alternative viable investment solution and has been an attractive form of investment with the advent of the self managed superannuation fund.

    Better yields

    As a rule, commercial real estate offers a higher rate of return which ranges between 6-9%, dependent on the location of the property, the length of the lease and the quality of the tenant.

    Potential tax benefits

    Depending on your financial circumstances, there are several potential tax benefits available when purchasing or owning commercial property. As with all advice, my recommendation is to speak with your accountant or financial planner who is across all your circumstances before making any investment decisions.

    Landlord favourable lease terms

    Commercial real estate property leases often are more detailed and can include clauses that are not permitted in a residential lease. Clauses such as tenant paid refurbishments during the lease period, restoring the premises at the end of the lease and so on.

    Where the average residential lease only allows a 4 week bond that cannot be increased in line with the any future rental increases, commercial leases are not restricted in the same way. Bank guarantees average 3 months with amounts of 6 and 12 months becoming more common especially in offices and may be increased at the same time as the rent

    Net income typically is higher than residential.

    Primarily this is due to the fact that quite often commercial leases pass the full responsibility for the cost of the outgoings direct to the tenant.

    Increased security through longer term leases.

    Whilst the average residential lease is 6-12 months, typically commercial leases are longer (3, 5 or 10 year’s) with fixed or CPI annual increases.

    The longer terms can assist in mitigating economic fluctuations that affects income.


    Why NOT TO Invest in Commercial Real Estate?

    Lack of knowledge

    Unlike residential real estate, commercial real estate is often a higher yielding but low-growth investment. It can also be harder for a property investor to understand what constitutes a good quality commercial tenancy and what is required to attract and maintain a quality commercial tenant.

    Historical and general research information is not as detailed or prolific as that of residential property and sourcing accurate and up to date information can be difficult.

    Inability to afford higher expenditure for the property

    Maintenance and running costs are often higher than residential property. Items generally not present in a residential property can be standard in commercial properties. For example water cooling towers, lifts, escalators and the like.

    Financing

    When purchasing commercial property, there is significantly more equity required and deposits are often higher than residential property. Amounts of 30-50% of the purchase price are not unheard of.

    You should be aware if lending the money for a commercial property purchase, interest rates are often higher as well.

    Higher Vacancy Periods

    How often have you seen a commercial property vacant for month’s (even years) in an economic down turn? Lease incentives such as rent free periods and capital contributions to assist in attaining tenants need to be taken into consideration both for a new tenant and to maintain an existing.
     
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  2. Ace in the Hole

    Ace in the Hole Well-Known Member Premium Member

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    Thanks.
    I've just started to consider commercial for my next purchase, only ever bought resi before.
    Trying to decide which sector to target, have most experience with industrial.
    Also trying to figure out if the higher rental yields will reduce future CG compared to resi.

    Another aspect of interest would be value add options for commercial, what are the more common techniques used here?
     
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  3. Scott No Mates

    Scott No Mates Well-Known Member

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    Upgrade Functionally obsolete buildings - the easiest to value add - eg: remove fibro, raise walls & shutter opening to take containers, upgrade services, new roofing etc.
     
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  4. Ace in the Hole

    Ace in the Hole Well-Known Member Premium Member

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    All good.
    The only concern then is, how long are vacancy periods when seeking new tenants.
    Would 6-12 months be quite common?
     
  5. chindonly

    chindonly Well-Known Member

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    Good post Chilli. I have an interest in commercial both from a work and future self investment perspective.

    Trying to get my head around Cap rate and making offers based on this.
    Obviously, different products and different markets have different Cap rates.

    But - how do you find out a suitable rate to apply, if you are not in the business all of the time?
    Also, is it based on gross yield, net yield?
     
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  6. Scott No Mates

    Scott No Mates Well-Known Member

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    Vacancies are very economy dependent - in the last 3 years, I have seen several deals where there was no downtime between tenants however it is very dependent upon the agent and their databases.
     
  7. Chilliblue

    Chilliblue Well-Known Member

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    Cap rates are commonly misunderstood and I have seen instances where they have not been calculated correctly.Essentially the cap rate is the ratio of net operating income to property asset value.

    Example: If a property was listed for $1,000,000 and generated an net operating income of $100,000, then the cap rate would be calculated as:

    $100,000/$1,000,000 = 10%
     
  8. Chilliblue

    Chilliblue Well-Known Member

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    This is where a piece of string line comes into play. There are so many variables that have to be taken into account and each property sector, the property itself and the current market condition play a part on the response.

    Light to heavy industrial properties generally have the longest vacancies but note that they also tend to have the longest lease periods applied.

    Essentially, when looking to add commercial real estate to your property portfolio, you really need to have a clear understanding what you are purchasing and the type of tenant you aim to attract.
     
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  9. Chilliblue

    Chilliblue Well-Known Member

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    Congratulations on taking the first steps.

    A really common value add ad the moment especially in Sydney is the conversion of commercial office building to residential.
     
  10. chindonly

    chindonly Well-Known Member

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    Thanks Chilli.
    The issue to me is what Cap rate to be applying when making an offer and real vs potential income.
    e.g. If a site is returning say $200k now, with some vacancy, they will want it calculated as if it was fully tenanted, and I don't!
    Also, applying either say 8% or 9% makes a huge difference to the offer price.
    $200k/ .09 = $2.22 M
    $200k/ .08 = $2.50 M
    And there are often very few comparable sales around.
     
  11. Dazedmw

    Dazedmw Well-Known Member

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    It can vary but the usual way to handle this is to calculate the value on a fully leased basis and then deduct loss of rental and leasing costs below the line.

    So if the fully leased market income was $200k net with a cap rate of 8.5% you get a core value of $2.35m. Then estimate how long it would take to lease up, say 6 months ($110k in gross rent lost), and what leasing costs would be (say $20k) and deduct those to get your offer price of $2.22m.
     
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  12. Pistonbroke

    Pistonbroke Well-Known Member

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    It's not always about you.
     
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  13. Chilliblue

    Chilliblue Well-Known Member

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    Chindonly is correct however note that the vendor may not share your viewpoint.
     
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  14. Ace in the Hole

    Ace in the Hole Well-Known Member Premium Member

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    What about property management with commercial?
    What do they actually have to do, if anything?
    If you buy a property with long lease in place, do you need ongoing property management?
     
  15. Pistonbroke

    Pistonbroke Well-Known Member

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    Yes no and maybe.

    With a gross lease probably not.

    Are you capable of preparing an outgoings budget and reconciliation? Have the ability to prepare the AFSS? Coordinate trades? Negotiate make good? Can you interpret lease clauses? Calculate rent adjustments? Then go for it.
     
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  16. chindonly

    chindonly Well-Known Member

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    I realize that, but if the site has a long history of not being fully tenanted, and has required significant incentives (above market) to get other tenants in there, that to me is a good reason to discount on the purchase price.
     
  17. Scott No Mates

    Scott No Mates Well-Known Member

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    Isn't that all the more reason for buying for potential? For what reason would it have been underleased? That is the opportunity to solve the issues with the building is it not?
     
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  18. Corey Batt

    Corey Batt Finance Strategist Business Plus Member

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    This all day long.

    In the end some of the best returns can be generated by resolving short term issues for long term gain.
     
  19. chindonly

    chindonly Well-Known Member

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    For this particular building, there are several reasons. Wrong product type for the dominant tenant in the area, A/c inadequate, building has not been maintained well.
    There is potential there, but will need some $ to fix. I am trying to price that in the offer, but they are (at least for now) ignoring these facts.
     
  20. Chilliblue

    Chilliblue Well-Known Member

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    Just place your offer in writing and keep following it up. Persistence may win out in the end.