30 Jan 2020
As a real estate investor, it is important to understand how risks and returns differ across asset classes even within real estate. Let’s look at Retail and Commercial Real Estate and understand some key differences between investing in the two.
A commercial asset investment would mean an investment in a standalone commercial office building or part of a business park where the tenant leases an office space. A retail investment would mean investing in a mall or high street where the tenant runs a retail store, restaurant or cinema.
|Lease Structure||3+3+3 years||5 years|
|Rent Structure||Vanilla||Min Guarantee or RevShare whichever is higher|
|Lock-in||3 - 5 years||1-2 years|
|Fitouts||Tenant / landlord||Tenant|
|Yields & Returns||7.5-8.5%||8-9%|
|Underlying industry||Technology / Financial Services||Consumer|
Commercial leases are structured as 3+3+3 which means a 9 year lease with a 3 year lock-in period and rental escalation (of 12-15%) every 3 years. Retail leases on the other hand are of a lesser tenure with either a 5% increase every year or 15% every 3 years. In fact, I would go so far as to say that escalations in retail leases are not as relevant because if the store does not do well, the tenant will likely vacate or not pay any escalations.
The biggest difference in the two is perhaps seen in the way the rents are structured. A commercial lease is a straight up fixed rent that escalates every year or every 3 years until the completion of the lease term. The rental cost for a large MNC like Microsoft or Google is very small as a % of total revenues. As such they are happy paying a fixed rent.
For a retail tenant, rental cost is sometimes as high as 20% of the store revenue. It has historically been seen that in order to be profitable, a store should have a rent to revenue ratio of 10-15% (also called a health ratio). A retail tenant will therefore try to align the rents to how the store is performing. Retailers negotiate for a lower upfront rent but agree to share revenues with the landlord in case the store does well. This structure is called the Minimum Guarantee + Revenue Share model.
The retail tenant agrees to pay a fixed minimum rent (“Minimum Guarantee”) that is lower than market and agrees to share a percentage of the revenues above a particular threshold (“Revenue Share”). For example in our recent listing in High Street Miraya Rose, Tata Zudio had signed a minimum guarantee rent of Rs. 70.7 psf (vs Rs. 90 psf market rate) and a Revenue Share of 6.5%. For an area of 8,400 sf, the sales that Zudio would have to achieve to start paying revenue share would be:
6.5% x Sales / 8,400 sf = Rs. 70.7
Solving this equation gets us Sales of Rs. 91,37,000 per month.
If Zudio achieves more than Rs. 91.4 lakhs, the landlord starts getting higher rent, as the Revenue Share number would start kicking-in.
You can see why this is a win-win situation for both landlord and tenant. If store sales are lower, the retailer can pay a lower rent to stay viable and if the store does well, paying a higher rent to the landlord will still be feasible. The landlord can also make a very lucrative return from a retail tenant once sales pick-up.
Lock-in is an important consideration in both commercial and retail leases. The way leases are structured in India; a landlord is locked-in for the entire term of the lease (9 years or 5 years) whereas tenants are locked-in for the lock-in period only. This is because the tenants spend significant amounts in furnishing the space and are wary of being asked to vacate by the landlord. In commercial premises, the company leasing the space also hires a large number of employees and sets-up IT and admin processes. They are therefore committed for a longer term to the space making them stickier than retail tenants.
Retail tenants only hire store staff and spend relatively lower amounts on IT and administrative services. In the case of these tenants it is more important to see how the store is performing in terms of sales and profitability.
Fitouts (Tenant Improvements)
In the case of office tenants, the fitouts are done both by the tenant and the landlord. In case the landlord does the fitouts, the tenant pays an extra fitout rent on top of the base rent to compensate the landlord for the additional cost. Since all commercial office tend to have similar designs, furniture and layouts, fitouts can easily be outsourced by the tenant to the landlord or an external agency.
n the case of retail tenants, the fitouts are very customized. A tenant like Zara has specific store designs and layouts, which are quite different from a tenant like H&M or GAP. Fitouts and store designs are a core differentiator in retail and are therefore almost always done by the tenants themselves. This makes the retail tenant stickier for the investor.
Yields and Returns
The returns from any asset depend on the riskiness of the cash flows that the asset generates. Fixed deposit rates are low because large banks have well capitalized balance sheets to pay interest and principal on time. In a commercial property the cash flows from rent are less volatile. Unless the tenant vacates, rental returns for the duration of the lease (including escalations) are known in advance.
In a retail asset, the rental cash flows depend on how well the retailer is doing. It is therefore more operational and volatile in nature. In a revenue share structure - daily, weekly and monthly sales reports are shared by the tenant with the landlord. The landlord therefore needs to be more involved in a retail lease than a commercial lease. Strong asset management capabilities become important in a retail investment. At PropShare we have a separate asset management team that works exclusively on assets post investment.
For this reason, retail yields (or cap rates) around the world are slightly higher than office yields as investor perceive retail to be a riskier asset class. The returns from retail properties are also therefore higher than commercial properties.
As an investor in the commercial office market, you are exposed primarily to the information technology and financial services industry. When you invest in an office space in a city like Bangalore, Pune or Hyderabad you are making a play on the IT industry, as the tenants are mostly technology tenants.
During the 2009 financial crisis, cities like Bangalore were fairly insulated as the tenants driving commercial office demand were mostly from the technology industry. In fact, more companies started outsourcing their operations to these cities in a bid to reduce costs, thus increasing demand for commercial office space. On the PropShare platform, we have many investors who work in financial services industries in Singapore, Hong Kong, London and New York, who want to diversify by investing in these tech-driven cities. As an employee in a tech industry, on the other hand, you might want to invest in Mumbai’s BKC which has predominantly financial services tenants.
As an investor in the retail market, you are exposed to the consumer industry. A retailer will do well when consumers have more disposable income; higher spending limits and spend a larger share of the wallet. As a retail property investor, you are making a play on the consumption story. In a country like India, this is a good bet to make as it is a consumption driven economy (vs say China which is a manufacturing or investment driven economy). The median age in India is less than 30 years, disposable incomes are rising and there has been significant urbanization over the last 15-20 years.
As a real estate investor, it is important to diversify your investments across both these asset classes so that risk and return might more meaningfully be distributed. Investing in these assets have been restricted to HNIs, Ultra HNIs and international property funds. However, PropShare makes it possible for ordinary investors to participate in an emerging market consumption story through retail or the technology and outsourcing boom through commercial real estate.
The author is the Co-founder and Chief Investment Officer at PropShare Capital ( www.propertyshare.in).