Commercial real estate is one of the most lucrative asset classes to invest in for the long term. It is one of the few hybrid instruments with characteristics of both debt and equity that also provides safety of capital. A few simple principles can be applied by any investor to ensure that he/she gets the maximum value out of this asset class while minimising risk.
Quality actually matters…
The best tenants occupy the best buildings. Period. Whether it’s Mumbai, London, New York or Hong Kong, Fortune 500 companies always occupy the highest quality buildings. Why? They usually come with high-end finishes, quality amenities, impressive lobbies, are built sustainably, have ample parking, high ceiling heights, and great views. When you buy a good quality office building, you get the best tenants which increases the value of the underlying asset over time.
…but Quality without Location is pointless
You can have the highest quality building but if it is located in a pioneering or off-market location, there are likely to be multiple issues for the investor. Location is one of the most important factors to consider before investing in this asset class. Location drives leasing, rents, rental growth, vacancy and ultimately returns. Investors should look for locations with an established office cluster and tenants, good quality infrastructure, low existing vacancy (<5%), low upcoming supply (<5% of existing stock in India), existing social infrastructure like hotels, hospitals, schools, restaurants etc.
The economics of demand and supply
Even the highest quality assets in the best locations can lead to sub-par returns in the back of high supply. The fundamenal economic principle of demand and supply is critical in analysing commercial real estate investments. The best example here is Hi-Tec City and Gachibowli in the Indian city of Hyderabad. This is a great location with some of the highest quality office buildings, Grade A tenants and superior infrastructure. However, there is a glut of supply expected over the next 3-5 years. What this means is that tenants can switch buildings easily, rents will fall due to competition among asset owners for the same tenants and vacancy will go up in exisiting and new buildings. That’s not where you want to be deploying your capital. On the other hand, you have Outer Ring Road in Bangalore, which has similar characteristics but very little upcoming supply, which makes it one of the strongest micro-markets to invest in.
Who is the tenant?
When we look at any property, the first question we ask is – Who is the tenant? The hierarchy of tenants in India is:
- Fortune 500
- Multinational
- Indian Top 100
- Others
Try to keep your portfolio in the top 3 because these tenants pay rents on time, are more professional in their dealings, do not negotiate for pennies and maintain the building very well. An office building with a good tenant is more liquid and commands a higher premium in the market.
Lease Structure
The general rule is to look for longer leases with a higher lock-in period. Lock-in period is the time during which the tenant is not legally allowed to vacate, giving the landlord visibility on returns. The typical lease in India is a 3+3+3 lease which means a tenant can stay for 9 years with escalations in rent (typically 15%) every 3 years. There is usually a lock-in of 3 years. Please note that the lock-in is an option only for the tenant. The landlord is locked-in for the entire 9 years. This is because, in India, the tenants usually spend significantly on the fitouts and have employees hired for that location. If the landlord were to ask the tenant to vacate after 3 years, it would involve significant disruptions for employees as well as monetary loss on fitouts for the tenant.
The curious case of fitouts
I always recommend that investors buy properties where the fitouts have been done by the tenant. This is because it makes the tenant sticky and they are unlikely to vacate in the short term. It makes them invested in the building and ensures that the landlord has the upper hand during negotiations at renewal or during escalations. We experienced this first hand during the COVID-19 pandemic where negotiations were a lot easier where tenants had spent on the fitouts.
Where fitouts are done by the landlord, tenants are not invested and can vacate for the smallest of reasons. Additionally, a trick that developers often use is including the fitout component (furniture, fixtures, etc) in the rent to show a higher yield to the investor but also increasing the purchase price. While the higher yield may seem enticing, the fitout rents depreciate over time and will lose most of their value by the end of the lease.
Boots on the ground
In real estate, everything is about the underlying physical asset class and the best way to assess any property is to physically visit it. This will give you a clear understanding of the property and bring to attention soft factors like the view of the surroundings, ease of access, proximity to public transport, the quality of maintenance, the amenities, etc. If for any reason, it may not be viable for you to visit the property, try to leverage technology through photos, drone videos, 360° virtual tours and Google Maps Street View.
Leverage is a double-edged sword
Commercial real estate typically has large ticket sizes and there may be a need to take a bank loan to purchase the asset. While leverage can help you generate higher overall returns, always be careful with the amount of loan taken. At a portfolio level, it is always advisable to have an overall debt of below 50%. This would mean that even if a tenant in one of the assets vacates, cashflows from other assets would be able to service the EMI payments, property taxes and maintenance charges.
Think beyond the yield
This is a slightly technical nuance but extremely important and often used by institutional investors to further break-down the underwriting of an asset. While rental yield is an important factor while investing in real estate, it is not the only factor. An example would help in understanding this concept easily. Let’s assume that there are three properties available:
Building A has Tenant X paying Rs. 10 and is selling for Rs. 100
Building B has Tenant Y paying Rs. 11 and is selling for Rs. 105
Building C has Tenant Z paying Rs. 9 and is selling for Rs. 95
At the outset, Building B seems the most lucrative as it has the highest rental return of 10.5%. However, Building C is the safest investment as Tenant C is the least likely to vacate as their rents are lower than the average rent of Rs. 10. In fact, even if C vacates, you will get an opportunity to lease the same space at Rs. 10 (the market rent) increasing your yield to 10.5% which will also provide an opportunity to sell the asset at a higher price. Thus, always benchmark your rent as well your capital value with the market and try to be below or at market. A good broker will have these values at the ready.
Say No to under-construction properties
Under-construction properties come with additional risks on title, approvals and construction. It is best avoided as a lay investor as the finer points of underwriting an under-construction asset require institutional investing experience. If you do contemplate investing, ensure that the development is financially closed – this means that the pending costs to complete are taken care of either though an approved bank loan or equity and there is a signed lease deed or LOI in place with a tenant.
Finally, the most important thing – the Price
Quality, location, tenant, market, lease strcutres are all great but if the asset is purchased at a high price, the investor is likely to make low or negative returns. The yield or the capitalisation rate (or cap rate) is the most appropriate metric to analyse a commercial office asset.
Yield = Rent / All-in Purchase Price
The purchase price must include all costs like registration and stamp duty, brokerage, legal fee etc. Yield is thus the return that the investor will make on his/her investment. Yield goes up by the escalation % every 3 years (15% as a general rule) and is therefore inflation indexed.
As a rule, the yield must be atleast 150 bps higher than the risk free rate (FD rate or G-Sec rate) to account for the higher risks associated with real estate investing.
Rahul Jain
The author is the Head of Investments and Asset Management at Property Share, India’s first and largest commercial property investment platform.
The article has also been published on Moneycontrol.com on 26th May, 2023.