Commercial property's high returns not reserved for big league investors
With residential property at budget-breaking levels in most capital cities, commercial property offers mum and dad investors significantly higher returns if they're willing to do the research.
In my last article for API Magazine, I pondered why more people aren’t investing in commercial property, as opposed to residential. With house prices some of the highest in the world relative to incomes, you’d have to wonder how much higher they can go?
Plus interest rates are falling, which could mean falling returns from residential, and the landlord tenant laws are typically investor-unfriendly.
In a climate of falling interest rates, there’s a way this can work in favour of commercial property investment.
Let’s start with what’s called the ‘risk-free rate’ – which is basically the theoretical rate of return for an investment with zero risk. The proxy are long term government bonds, and the measure is the RBA’s cash rate. That’s currently 4.1 per cent.
Residential investors often buy below that rate because they have high hopes of future capital gains driven by land value or capital enhancement, not rental income. But in commercial property, the expected rate of return is nearly always higher, due to the degree of risk.
Low risk commercial property – something in an excellent location, long term leases, new building with lots of depreciation, super strong tenancy profile etc – is the lowest risk, hence lower returns. That’s perhaps 5.5 per cent or 6 per cent in the current market. Higher risk investments – typically smaller properties with fragmented lease profiles etc – may instead show returns of 8.5 per cent.
Transforming a commercial property into a winner
Let’s look at an example where an investor buys a small commercial property with say five tenants. It’s producing a net annual income of $275,000 and they paid $3,500,000 for it. That’s an initial yield (income divided by price) of 7.9 per cent.
The investor then goes about tidying up the lease profile (which is what generates the income). There’s one tenant who has been there since Adam was a boy. There’s no lease – it’s just a long term mutual agreement to pay the rent. Another tenant is struggling because their type of business is struggling (many newsagents, for example, fall into this category). This story is more or less repeated in one or two more of the tenants.
The investor moves our long-term tenant back onto a fresh lease of five years with options. If the tenant doesn’t want a lease, fair enough – find a tenant that does.
Our newsagent, while on a lease, is offered to be released. Our investor knows of a medical practice that would like to be in this location. Newsagent out, doctors in – also on a fresh lease of 5 years plus options.
All tenants have their rents reset to market rates (the property was under-rented when bought) and a number of building defects are remedied at relatively minimal cost. Outgoings and operational costs are put under the microscope for best value solutions. The entire property is given a new lease of life.
In the meantime, the risk-free rate has fallen. The RBA cash rate is now 3.5 per cent. Yields are therefore also down – sometimes known as yield compression (the gap between market returns and the cash rate narrows).
In this case this is good news for our investor. Because they have improved the risk profile of the property (new leases, solid tenants etc), their property is more appealing to other investors. The net annual income has increased to $350,000 thanks to resetting market rents, better tenants, and managing the outgoings.
But the important variable now is what’s called the capitalisation rate – which is essentially the same as the initial yield but in reverse. This is the rate at which the annual income will be capitalised to reflect the risk.
Our initial yield was 7.9 per cent for a property that needed work. We can now capitalise the income at 6 per cent to reflect lower risk, and the downward move in interest rates.
The $350,000 income capitalised at 6 per cent equals $5.833 million (income divided by 6 per cent) or a 67 per cent increase in value. The $3.5m commercial property is now worth closer to $6 million. Would the same have happened to a comparable residential property investment in that time?
This is of course a highly simplified scenario. But it’s worth keeping in mind how the magic of yields, cap rates and incomes work when evaluating commercial property as an investment. It’s not something reserved for the big end of town – smaller private investors can play in this space too.
