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Commercial Property 101

A great many kiwis love to invest in residential property. And why not? In general the sector has performed strongly over many years, is relatively easy to understand, allows leverage through borrowing, and with DIY permits scope to add value through your own effort and creativity.

After getting a few successful residential deals under your belt, and imbued with a sense of imminent world domination - you might be tempted to try your hand at commercial property. But beware - the commercial market is incredibly sophisticated and you’ll quickly find yourself in deep water. Your competition is generally better informed, better resourced, and can sense a new player like an Orca senses a lone seal.

So what’s the big deal? There are a great number of factors - but the main ones are that the drivers of value are quite different between residential and commercial.

You’ve no doubt heard the adage about the three most important things in residential property - “location, location, location”. A touch simplistic, however the corollary with commercial would be “contracts, contracts, contracts”. Specifically the strength and integrity of the lease, and the entity behind it.

With residential it’s pretty straight forward to gather some sales data, look at listings on Trade Me, identify a ‘do up’ and estimate the cost of a small renovation. We understand intuitively what buyers and tenants want and can judge how to oblige. It’s also not too difficult to work out a market rental.

In commercial there’s much more to consider, but in this brief post I want to highlight the biggest threat to a new commercial investor - the hydraulic rental.

The value of a commercial property is largely dependent on the rental income it can generate, the surety of receiving that income, and expectations of growth in that rental level. Many of these are in turn governed by how desirable and profitable the space is for the occupant. And every occupant business is different. One values foot traffic, others like parking, another might need lots of storage.. there are infinite possibilities and market rent is analysed for each component separately - not just $X per week for the lot like a house.

And here’s the game. A cunning commercial property operator knows that it is hard for you to judge market rent accurately. They also know that the value is largely determined by a multiple of the rent (remember: contracts, contracts, contracts?) So the higher the rent, the higher the sale price - at least to an uniformed buyer.

A leaseback transaction is a common example. Let’s say a mechanic owns his business and also the building he operates from. Also let’s say a fair market rent is $40,000 per annum and properties like his are selling for a 5% yield. That means his property might be worth $800,000. So he decides to sell the building and keep leasing it from the new owner (leaseback) But now he gets clever... How about if I write a lease to myself for 3 years at $50,000 per annum? Now the property is worth $1,000,000! And herein is the trap. The buyer doesn’t know that $50,000 is unrealistic (there is no database to check or comparable rentals advertised)..

The buyer just paid $200,000 too much, and all it cost the vendor was $10,000 x 3 years - and that $30,000 is tax deductible!! His capital gain however was tax free.

At the end of the lease term the tenant will quite likely vacate - and you will not be able to find another tenant at the elevated rental, forcing you to drop back to the market rate (and also pay agent fees etc). Alternatively he may stay put and negotiate the rent down at renewal time - or at a very minimum you won’t see any rental growth until the market catches up.

If you had a 50% deposit - so bought it with a $500k mortgage - your equity is now $300k. Congratulations on your negative 40% return on investment in one day. Not bad!

The reason residential is generally safer (and banks will lend a greater percentage), is because location can’t be manipulated. Contracts most definitely can (and are). So watch out, and don’t assume you can judge commercial property deals in same the casual way you might visit an open home.

Due diligence is critical, and mistakes cost plenty. If you want to play the commercial property game, educate yourself, build a team of advisers, and take your time. The devil is most certainly in the detail.

Take care, 
Scott Morison