Commercial Property?

December 04

Scarcely a week has passed this year without some organisation or other reporting that investors are supposedly turning to commercial property owing to lower yields in the residential sector.

At the moment, I can see little evidence to support the claim that, but lots of evidence that some organisations are trying their hardest to SELL commercial property deals to individual investors.

After many questions about this, I thought it was worth a quick refresher on the advantages and disadvantages of commercial property. First the good news:

Firstly, commercial property can, with the right tenant, be much less work for the landlord. Not only do many commercial leases require tenants to take care of minor maintenance issues, but those tenants are far more motivated to deal with those minor issues. Faded paintwork at home might mean a call to the landlord. Faded paintwork in a shop or office will send the wrong signals to the tenants own customers, and therefore tenants are more likely to get out the paintbrush and keep everything looking smart.

Secondly, the actual terms of a commercial lease are far more important. If a commercial tenant is late a week with the rent, and the lease stipulates that this invokes a penalty of two weeks rent, then that penalty is likely to be binding. A week delay in residential rent is most unlikely to get any such claim past a court.

Now the bad news:

Property is inherently an asset that only makes great returns when leveraged. It is far harder to get high loans to value on commercial property than residential, and those loans often come at an interest premium over residential, buy to let, loans.

Finding tenants can be much harder work. When all is said and done, most empty flats and houses are empty for one reason - the asking rent is too high. A reduction in rent normally leads to a tenant being found and at least some income. By comparison, there are numerous empty offices, not because the rent is too high, but because there are so few commercial tenants wanting that type of space. After all, a third-floor space laid out as a laboratory space in a science park will only attract a certain type of business.

As a result of this, commercial property is often valued using techniques such as Discounted Cash Flow (DCF), in which the most important things to know are the current rent being paid, the length of lease remaining, and the type of tenant. Two shops with identical floor areas, next to each other, might go for wildly different prices if one is let to a large retailer, on a 21-year lease, and the other is let to an independant startup, on a short term contract (or worse, standing empty.)

Finally, do not get lulled by how wonderful a commercial building looks. This is dangerous enough in residential investment, but can be fatal in commercial investment. Just because a building is fitted out as a carrier-grade data hosting centre does not mean it will be easy to find a tenant (data hosting centres worldwide are running at about 70 per cent vacancy rates.) Just because a building is new, clean, and full of modern fittings does not mean that local businesses will pay a premium for such a building.

I should state, for the record, that my own portfolio does not contain any commercial property. At the moment, I am finding that there are still such good returns to be made in residential that I do not need to take on the extra risks of investing in areas in which I have not done the same amount of research.

This is just the feature article from the December 04 newsletter. Subscribe for market comment, forthcoming events, and more.

---