Advanced investors are always looking for new financial vehicles to consider and commercial property is one such option that’s growing in popularity.
Unfortunately, some investors don’t fully understand its unique peculiarities, including the importance of leases.
With the growth of super fund investment in property, along with it has come a surge of interest in commercial property.
However most beginner commercial investors have little knowledge about how to gauge the worth of a commercial property and tend to start this assessment by looking at the property by looking at the property in much the same way as they’d look at a residential purchase.
A different mindset is required when assessing commercial properties, as the single most important issue is the lease.
More than anything else, with a commercial property it’s all about the terms of the lease.
Let’s consider some of the matters you should consider as the potential buyer of a commercial property.
You should also appreciate that there are some compelling financial reasons to consider commercial real estate if you haven’t done so before, because it can have significant advantages over residential property.
Some of these attributes are summed up by Dolf de Roos, New York Times bestselling author of Real Estate Riches and prolific commercial investor, and remember too that most wealthy Australians hold their wealth not in residential property but in commercial.
Better security against an economic downturn
The effects of an economic downturn take longer to play out with commercial properties as tenants are generally locked into leases lasting multiple years.
Conversely, residential lease are seldom longer than 12 months’ duration so residential tenants will feel an impact almost immediately.
With this in mind there’s a buffering with commercial property.
Tenants pay the outgoings
You rarely put your hand in your pocket with commercial properties like you do with residential properties, where almost every single maintenance item is your responsibility.
Tenants earn their income on your premises
This gives them an incentive to keep the property looking good and results in commercial properties generally being better cared for than residential properties.
When a landlord does pay for improvements, they can often increase the rent and thus the value of the property.
There are regular built in reviews and increases of the rent under the lease document, which isn’t usual with residential leases.
Less government interference
The do-gooders around the country that have driven the unfairly-weighted residential tenancy legislation in favour of the tenant haven’t penetrated the commercial property world.
The discussion that follows is essentially about commercial and industrial leases since retail leases are governed by specific legislation in each state across the country and are heavily regulated.
And to help you along your commercial property investment journey here’s an example checklist to keep in mind too.
Commercial Lease Checklist:
1) Term of the lease
This is the number one item.
If the selling agent has represented that the lease is for a term of 15 years, check whether this consists of an original term of five years with two additional five-year options.
A five-year term with two extra five-year options is not a 5-year lease.
You have to treat it as just a five-year lease and then assess the likelihood of the tenant exercising the options.
Therefore, a five-year term with two five-year options is a far more tenuous security than a straight 15-year lease.
You’ll have to make an assessment of the likelihood of the tenant exercising the option.
Understand that there’s a stronger likelihood of the tenant exercising the option if they’ve paid goodwill or key money for the business on top of the costs of the fit out of the premises.
If they’ve paid for the goodwill of an existing business and taken a transfer of the lease as part of that, then there’s a better prospect they’ll exercise the option as it usually takes them quite a number of years e.g. three, four or five years to get back the money they paid to the seller for goodwill.
Therefore, they have a greater commitment to the business and consequently the lease.
For example, even a hairdresser who paid $60,000 for a hairdressing business, plus the cost of hairdressing equipment, will be very likely to exercise an option to extend their lease because they need to get back the $60,000 paid for goodwill.
Therefore, a tenant who has bought the goodwill of a business plus the cost of the fit out is a much stronger tenant.
For example, motel leases are nearly always renewed for this reason as the owner of the motel business not only paid for the cost of the fit out of the motel and the gear that went with it, but often paid three to four times the annual net profit of that business as a capital cost of acquiring it.
Tony Lenan, principal of Firestar Developments Pty Ltd and a seasoned commercial investor, has strong views about his issue.
He says that the value and position of a commercial property depends on how re-lettable it is once the existing lease expires.
“A five-year lease in a retail area, say in Cavill Avenue in Surfers Paradise, is a lot more re-lettable than a five year lease over a service station in chinchilla, Queensland.”
So generic uses such as offices are far more re-lettable at the end of the term than special purpose leases such as car dealerships, car washes, fast food outlets and service stations.
You need to ask yourself the question, “What will I do with this site at the end of the lease?”
And you also need to ask, “Who is the tenant?”
John Potter from The Potter Group and author of A Property Investor’s Guide to Negotiating says another question to ask is about the length of the term.
“The very first question therefore about any lease should be how long is the term?” Potter says.
“You should understand that options in leases are only for the comfort of the lessee. It’s a critical point to understand that options aren’t in the lessor’s favour.”
2) The Rent – gross rental vs net rental
About 70 per cent of leases are gross rental.
That is, the landlord pays all the outgoings with the other 30 per cent net rentals, where the tenant pays outgoings.
From a commercial investor’s perspective, net leases are the best.
Then no matter what new outgoings, taxes or expenses come along you just pass them onto the tenant.
Over recent years, we’ve seen a blowout in such things as water charges, body corporate levy increases and insurance costs.
With a net lease, none of these will worry you because the tenant will pay at the end of the day.
Carefully check a lease that’s a gross rental and make sure you’re fully informed about what the outgoings actually area, and whether there will be any increases such as water usage, insurance, etc.
Air conditioning costs and maintenance are classic examples.
When reviewing a g ross rental that you’re carrying out a due diligence on you might say, “Oh well I have to pay the air conditioning costs as a landlord but it’s only $1000 a year.”
You should know that this $1000 goes to the bottom line i.e. if you’re buying the property on a 10 per cent yield, the capital cost of you absorbing that $1000 outgoing is $10,000.
“There’s a big difference between a gross lease and a net lease because the outgoings under a lease are often about 20 per cent of the rental,” Potter says.
“So, if for example, you’d normally buy commercial premises at a yield of 10 per cent but he lease was a gross lease and not a net rent lease, the yield you’d want to pay as a buyer and commercial landlord would be 12 per cent, not 10 per cent.”
Therefore you must read the provisions of the lease very carefully.
In the commercial property world, far more than in residential property, you must become the best generalist you possibly can.
Don’t flick-pass the problems to your lawyer, town planner or accountant.
A big part of becoming a successful commercial investor is in knowing as much as you possibly can about leases.
And that translates into doing.
It’s in the doing that the prize exists, not in the espousing or the philosophising of it.
So roll up your sleeves and get in and learn about it if you want to own commercial property.
3) Rental increases
According to Lenan, the best type of rental increase is the one that includes some actual real growth.
“Like a fixed rental increase (over the next five years) a five per cent a year,” he says.
“CPI by itself just isn’t good enough. It should at least be CPI plus a minimum of one or two percent a year.
You need growth and ideally you need a market review of the rental every three, or at least every five years.
This can be a bit of a hard sell with a tenant, but it’s worth pushing for as you must have a lease that has growth.”
4) Fixed rental increases vs percentage rent
Some leases provide that the rent increases by a fixed percentage each year and others provide that the rent will increase by a percentage of the tenant’s gross takings.
Leases which provide for an increase in line with the tenant’s increase in gross turnover (percentage rent) are far less attractive to a commercial investor than a lease that provides for a fixed rental increase each year, or even CPI (cost of living) increases.
Percentage rent increases negatively impact on the yield the property is sold for.
Investors will want to know not what they might get out of the rental, but what they do get.
If the yield for the property you’re buying would normally be about eight per cent, then because the rental increase is all percentage rent, the market place will usually reduce the sale price and the yield down to say nine or ten per cent.
A lease that provides just for CPI increases will leave a landlord seriously financially disadvantaged over even five years.
The CPI is a very poor means of gauging cost of living increases as politicians have played around with it so much.
5) How to value commercial property
Unlike residential property, the value of which is often very speculative and driven by general movements in the real estate market, the essential value of commercial property is based on the rental income it generates.
Dolf de Roos says that the capital value of a commercial property is worked out by the following simple formula (where the cap rate is the average of all the yields of similar buildings nearby):
Capital value = rental/the cap rate
If rental properties are sold in the area you’re looking in at an average cap rate (yield) of 10 per cent, then the market value of such a property, which had a tenant paying $100,000 per annum would be calculated as:
Rent ($100,000)/10% = $1,000,000
While we don’t have any control over the cap rate as the market drives it, commercial property owners do have an influence on the rental income.
This brings it into sharp focus for you and underscores the fact that the lease document is everything.
Read it carefully.
Now you hopefully understand why the lease and the provisions about rental increases and who pays for the outgoings etc. are so very important.
6) Property use
It’s vital to check that the use the tenant makes of the property is lawful.
Conversely, most tenants want a guarantee that the use is lawful.
So it’s essential that you check, as part of your due diligence, that town planning approval has been given for that use.
Otherwise the tenant can simply leave under most leases and then you’ll need to find a tenant at the next highest and best use of the property.
You might be leasing a car yard out for $100,000 a year rent but if town planning approval hasn’t been given for the car yard, it might be that the next highest rental is $50,000 a year.
At a 10 per cent yield this translates to a drop in value of $500,000. Ouch.
Gyms are a good example of this.
There are a lot of casual gyms around which don’t have town planning approval.
The reason usually is that more car parking is required than can be provided on the site.
In addition, gyms can often attract a lot of negative feedback from other tenants and annoy them because gym classes often pour out into, and are conducted in outdoor parking areas e.g. skipping or boxing classes.
There are also a lot of guys running around with tatts wearing tight fitting t-shirts. Who orders them around?
7) Car parking
Firstly you must carefully consider the obligations you would have as the landlord of the premises, should you buy it, to provide car parking spaces for all of your tenants on site.
Secondly, as part of your due diligence, you need to check that the car parking on site complies with the council requirements for your tenant’s use.
For example, leasing the premises to a gymnasium attracts high car parking requirements, whereas a storage facility has a lot less demand and need for car parking spaces.
Watch out tomorrow for part 2 of this two part article.
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