Featured in Economic Times Wealth on 10th December 2017.
10 Commandments of real estate investing
Commercial real estate investing is not as difficult as it may appear. If you follow the basic principles of long term investing, you can earn much higher returns compared to fixed deposits and other debt mutual funds. But there are some things to keep in mind while becoming a successful commercial property investor:
1. Location, location, location
We have all heard that location is everything in real estate and this goes for commercial property as well. The Commercial property provides returns to the investor through two avenues – Rent and Capital Appreciation and both are heavily dependent on the location. Look for locations that have less than 5% vacancy. 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.
2. Quality: B, B+ or A
Two buildings may be in the same location, but the one with a higher quality will always get rented first and will attract higher quality tenants. It will also get the investor higher rents, better tenant retention and higher capital appreciation. Multinational tenants will pay a premium for higher quality. Look for certification like LEED gold or platinum ratings or buildings which have nicer lobbies, more lift banks, higher ceiling heights and better views. Higher quality properties are also more liquid and can be sold much faster.
3. Demand / Supply
This is one of the first things a savvy investor has to analyse before committing to purchase a commercial property in India. Every city has different micro-markets. In Bangalore, 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 are likely to come down. A disproportionately high supply will affect both new and old buildings. New buildings will command lower rents as tenants get more options available in the market while tenants in older buildings will renegotiate rents and escalation clauses.
4. 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 the same price but each with a tenant paying different rents.
Building A has tenant A paying Rs. 10 and is selling for Rs. 100,
Building B has Tenant B paying Rs. 11 and is selling for Rs. 105
Building C has Tenant C 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 over-rented asset at an above market price.
5. Quality of tenant
A good tenant can significantly increase the value of a commercial property. Looks for blue chip multinational tenants like Google, Microsoft, Goldman Sachs and avoid smaller and unknown companies. Good tenants pay rents on time, pay higher deposits, stay longer and increase the value of the property.
6. Interior fitouts
As an smart real estate investor, you should always ask who has done the interior fitouts in the property. When an office is delivered in India, it is provided the 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 fit outs 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 sf and developers charge Rs. 25-30 per sf per month (Rs. 300-360 per sf per year). A tenant who has done his own fitouts is likely to stay longer in order to sufficiently recover the costs making them stickier.
7. 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 psf and fitout rent is Rs. 30 psf, the tenant will pay Rs. 80 psf (Rs. 960 psf per year). If the normal selling price is Rs. 6,000 per sf (where the tenant has done his own fitouts), a developer may try to sell the fitted-space for Rs. 9,000 psf promising a higher return of 11% (960/9,000). While this may sound enticing, the fitout rents will stop after 5 years dropping the return to 6.7%.
8. 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 meaning the tenant can vacate at any time whereas the landlord cannot ask them to leave for the lease period. There is also a concept of lock-in period (generally 3 years) during which time the tenant cannot vacate the property. While analyzing 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.
9. Security deposit
Security deposit in commercial properties varies between 10 and 12 months. 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. Start-ups typically tend to ask for smaller deposits and shorter lock-ins.
We’ve all heard that diversification reduces risk. This is especially true in commercial real estate investment. 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 property-level risk.