Commercial real estate: Guidelines for retail investors

Ramesh NairJones Lang LaSalle India

Buying an office or retail space is a huge investment, which is why commercial real estate has been traditionally seen as an asset class that only institutional investors or heavyweight HNIs could invest in. That, however, is changing. Many retail investors are now getting into the office real estate game. 

For a perspective of the opportunities in Indian commercial real estate, consider this – Manhattan in New York City has 450 million square feet of Grade A stock, while London has 200 million square feet. In comparison, India’s collective office space stock accounts for only 375 million square feet. This showcases the long-term potential for office space at all levels in India.

Very few of the world’s commercial real estate markets have undergone such a dramatic and rapid change in such a short span of time as India’s has. The next few years will see a quantum spurt in the services and knowledge sector, opening up tremendous opportunities for the retail investor.

INVESTMENT ROUTES: 

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Ramesh Nair

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There are three ways to invest in commercial real estate – directly buy office space from a developer, buy shares of a commercial developer from the stock market, or invest in a real estate fund focused on commercial real estate. As the quantum of investment is usually huge, the prospective buyer needs to take more informed decisions. Another option, which is investing in Real Estate Investment Trusts, is expected to be opened up shortly by the government. REITs are pooled investment entities where the corpus is invested primarily in completed, income yielding real estate assets and distribute a major part of the revenue/income generated among their investors. 

Many developers, especially in cities such as Mumbai, are today offering smaller units of space (as small as 500-1000 square feet) in Grade A buildings given the higher vacancy and pressure on pricing. This is in sharp contrast to the scenario a few years back, where only much larger units were available – making it tough for a small investor to invest in office real estate. Investors considering retail space can now consider a multitude of affordable options in free-standing high street outlets or shops in malls.

The advantages of smaller units are two-fold: 

* It is  easier to find tenants for them

* The premises can also be used for business by their owners if they happen to be of an entrepreneurial bent of mind 

Today, even professionals like doctors, auditors, stock brokers and lawyers are buying commercial properties for investment and self-use. Of course, HNIs also continue to plug huge amounts of money into high-ticket commercial properties in the quest for yield. Private bankers and wealth management firms confirm that their clients have actively started investing in commercial properties after staying away in 2009 and 2010. These investors have bought into commercial properties because they seek assets that can protect their portfolios from inflation and stock market volatility. On their side, banks are willing to lend up to 50-60% of the LTV to buy commercial properties, subject to the borrower’s adequate net worth and established ability to repay. 

The investor should focus on a few carefully selected markets with a diverse economic base, deep pool of tenants and tenants who like quality buildings. While looking at under construction projects, the investor should look at developers who have a track record of delivering high quality projects on schedule.  

WHAT TO LOOK FOR: 

Despite the availability of more rationally priced options, investing in commercial real estate is most definitely not child’s play. It requires forethought, research and planning:

* Investors need to establish the soundness of the location and its demand/supply dynamics. If they do not engage in sufficient research, they may end up buying into micro markets which have or will have high vacancies.

* They need to ensure that the economy, job market, future infrastructure development and population growth in the market is healthy

* They need to check the developer credentials, access to public transport and quality of property management in the project

* They need a knowledgeable real estate agent and a lawyer who can give them sound advice

* If they are investing in a retail store, they need to consider the frontage, foot-fall and the dynamics of the adjoining catchment

* Entrepreneurs who wish to buy commercial real estate for self-use should ensure that the amenities in the project that match their business needs

If an investor is looking at an income producing office asset, he should look at:

* The break-up of cash flows

* The vacancy factor

* Expenses such as maintenance, property tax and building insurance

* Lease term, lock-in period and expiry dates

* Long term capital appreciation potential

* Refurbishment, refinancing and repositioning potential

WHY INVEST? 

The rental yield for commercial property is usually 9-11%. In contrast, the yield for residential property is much lower at 2-3.5%. The demand for office space in India is likely to stand at around 200 million square feet over the next five years. Post the GFC, the prices in markets like Mumbai have dropped around 35-40% and have bottomed out in most micro-markets, offering investors a good opportunity to buy into commercial real estate. 

India’s macroeconomic growth story makes for a rather compelling reason to get one’s own paragraph into it somewhere. Chosen prudently, and office real estate can let you do that in indelible ink. Last year, the demand for office space across India was 26 million square feet and this year is expected to see demand of 28 million square feet. The possibility of diversifying one’s portfolio, the sheer pride of ownership and the benefits of the longer leases that typify commercial tenants are other reasons to look at commercial real estate investing. 

Remember, you do not only make a profit on the sale of appreciated commercial property – the rental cash flows of a well-located office or shop space are considerable. Unlike in residential property, the income that can be generated from commercial property is what determines its value. In other words, the capitalization rate is actually the measure of the demand for the property. For those who do their homework well, investing in commercial property is a high-adrenaline and high-returns game that residential real estate investment cannot hold a candle to…