30 Jul 2020
Commercial real estate has always remained an attractive asset class for high yield investment. Compared to other yield products like fixed deposits, debt funds, AA/AAA rated paper, investing in CRE provides various additional benefits especially to the NRI investor.
There are tech-enabled commercial property investment platforms that guides NRI investors to diversify their portfolio by investing in rent-generating commercial properties in Tier 1 cities in India. NRIs comprise of investors, who come from diverse backgrounds like oil and gas, financial services, technology, manufacturing, among others. Here are some of the benefits and potential pitfalls of CRE investing.
Commercial real estate’s attractiveness stems from the “yield”, the rental return that an investor earns from investing in a leased commercial property. Yield is nothing but rents/all-in price.
It is important to note that it is 'All-in' price and not purchase price. Many inexperienced investors wrongly calculate yield as rent/purchase price without factoring additional purchase costs like registration and stamp duty, lawyer’s fees, brokerage etc. These costs tend to add up to 10 percent to the purchase price and can therefore reduce the yield by 10 percent.
The yields on CRE can be between 7-9 percent, much higher than the 4-5 percent currently available on FDs or 7-8 percent on AAA debt funds. In situations such as the COVID-19 pandemic, NRI investors can increase their yield further by making use of the depreciation in the rupee/dollar exchange rate. A 5 percent depreciation can increase the yield from 8 percent to 8.4 percent.
Commercial leases have built-in escalation in the contracts of 5 percent per year or 15 percent every three years to account for inflation. This increases the yield on the return in-line with inflation keeping the real return post inflation constant. This is an often overlooked benefit of CRE investing that is attractive to long term real returns.
An inflation linked return helps NRIs create wealth in India without depleting the value of their investments or returns.
CRE is a hybrid instrument that provides not just monthly cash flow and yield but capital appreciation as well. The underlying real estate and land appreciates in value over time providing a “kicker” to the overall returns. A 5-10 percent capital appreciation increases the total returns or IRR to 15-20 percent per year.
No other instrument provides this high a return for the low level of risk. The only real risk of investing in a CRE asset class is vacancy which an astute investment manager can avoid through various conservative investing principles like choosing the right building, location, tenant and completing a thorough due diligence through Tier 1 law firms.
It is important that a new investor looks out for few important factors, while investing in the CRE asset class. Unlike other asset classes like FDs or mutual funds, an investor needs to be careful of a few basic fundamentals of CRE investing. This is also the reason why CRE has until now been the preserve of institutional investors and family offices.
Type of property and tenant
Yield on the property can vary according to the grade of the building. A Grade A building with world class amenities, high parking ratios, impressive lobbies and outstanding services tend to attract better tenants. It therefore stands to reason that these properties are in higher demand with lower yields.
Grade B and C properties on the other hand tend to attract second tier tenants who may not be as prompt in rent payments, may have a weaker balance sheet and might vacate properties often.
As an investor, always invest in Grade A properties even if the yields are slightly lower as they tend to be rented to high quality multinational blue-chip tenants and are much more liquid I.e. easier to dispose off. As an NRI, it maybe difficult to travel to India multiple times to view properties
Market rent and micro-market vacancy
Market rent means the current rent in the market today if a new lease were to be signed. On the other hand, in-place rent is the rent that the current tenant is paying in the building you may be looking to purchase. Always, buy properties where the in-place rent is at or lower than the market rent.
This is because this makes it more difficult for the tenant to switch buildings for rental costs. If the rent in the market is Rs 50 per sq ft and the property that an investor is planning to purchase is tenanted at Rs. 60 per sq ft, the tenant has a very high incentive to vacate or renegotiate rents.
This also means that the yield is artificially inflated. Imagine the current COVID-19 scenario where a lot of tenants are looking to renegotiate rents. If the property has a lower rent than market, then it will be in a much better position for the investor to negotiate. Similarly, choose properties in micro-markets that have very low vacancy ( <3-5%). When there is a lot of supply in a market, tenants get a lot more option to negotiate.
Any property is as good as the legal title. A lot of the legal risks can be avoided by purchasing ready-to-move leased commercial properties with occupancy certificates in place. The receipt of OC means that the building has already satisfied all the municipal and government approvals required to begin operations. When an MNC tenant occupies a building they would also have done a legal diligence already. For verifying the title of the property and necessary document it is of paramount importance to consult a Tier 1 law firm.
CRE is a very attractive asset class for NRI investors providing stable cash flow and high risk adjusted returns.
The author is the co-founder and chief investment officer at PropShare Capital, India’s first and largest commercial property investment platform.