Commercial property – Part 2: Determining value, Real Estate Investment Trusts, Warehouses, Mixed Use, Leases, and more (Ep.63)

In this week’s episode of the Property Planner, Buyer and Professor Podcast, the team explore the commercial property sector in part two and share with you how to determine the value of a commercial property, what to look for in a tenant, investing in real estate investment trusts and the ins and outs of warehouses – and more!
David Johnston, Cate Bakos and Peter Koulizos discuss:
  1. How to determine the value of commercial property when buying. The Property Professor explains what determines the value of a commercial property and what to look for in a quality commercial investment.
  2. Land tax. Due to the higher cost of getting in and out of commercial real estate, land tax must be considered as part of the ongoing costs and factored into your decision making. For most states and territories, land tax is grouped with residential property. Be sure to do the sums on your land tax bill because the costs grow proportionately to total aggregated land value. Take a listen to Ep#43 “Diversification 101 – How and why to plan for diversification within your property portfolio” for more on this topic.
  3. What should you look for in an ideal tenant? Long-term lease agreements and stable companies or government organisations can be your best friend!
  4. Unpacking warehouses (pun intended!) Everything you need to know about investing in warehouses and logistics. This category has outstripped office and retail for popularity and overall returns with the advent of online shopping, and Covid has only hastened this transition. However, there are some traps for new players!
  5. Real Estate Investment Trusts (REITs) – The pro’s and con’s, and everything in between. REITs are a great way to gain exposure to commercial property without having to outlay millions of dollars on a single asset, which brings huge concentration risk. REIT’s offer instant exposure to commercial real estate in a bite size chunk that suits your investment profile. No need to buy the whole shopping centre or office. You also can get exposure to various properties across office, retail and logistics providing diversification. REIT’s are a great way to provide cash flow as part of your transition to retirement as a trust must distribute all profits, unlike companies.
  6. Publicly listed V unlisted/private Real Estate Investment Trust’s (REIT’s). Unlisted property funds are the closest proxy to direct property investment – but with the benefit of professional management. A major con is that your capital is locked in for the duration of the trust as private units cannot be bought and sold on the ASX in the open market, which usually ensures greater liquidity. If you are selling, you may be required to sell to someone within the private REIT. If you are worried about liquidity, this is not the asset class for you and you would be better off in a listed REIT.
  7. Flexibility of the property to mitigate risk. Investing in commercial property comes with higher risk than residential for many reasons, but you can mitigate that risk by purchasing a property that allows for flexibility of tenant types.
  8. Let’s go in reverse, beep, beep, beep, how about converting a warehouse into a residential property?! The ‘latest’ craze in modern living, well actually this has been happening for two decades as industrial property in inner cities cease being used for their original purpose and transition to residential property. Warehouse conversions can pay off from a lifestyle and financial perspective, but often do not. They are high risk, and are not for the faint hearted (or those with a tight budget). So go in with your eyes open and be sure that the property really is your dream home, or the investment will get a sustainable long-term financial return. Enter at own risk! Caveat emptor!
  9. And of course, our ‘gold nuggets’!

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Show notes

  • How commercial properties are valued – residential, looking at features, facets and elements and other comparable properties. Whatever they are renting for and how long the tenant has been in there have no bearing.  
  • The key ingredient to valuing a commercial property is the rental yield – if you’re getting $50,000 a year and the property is worth $500,000 – that is 10% rental return. You want to increase the value of the commercial property, you need to increase the rent – that is up to the landlord. They must improve the property – update it air-conditioning, new facilities etc.  
  • CPI is agreed and factored into rental agreements – how much it will go up each year.  
  • How long a tenant is yet to serve on their tenant and how many options to extend – discounted cash flow. If someone gives you $100 next year is not the same as $100 this year. If we’re talking a long-term lease, the rent may be $50,000 a year and then goes up by 2%, you have a look at all future cash flows and bring it back to a present value. If there are no options, then there must be a vacancy rate factored in.  
  • Quality of tenant – whether Centrelink or whether a video store is the tenant, it is valued the same.  
  • Land tax – with most states it’s grouped with residential. Generally the land value is so high for commercial that you will fall into at least the first tier of land tax. All states have differing tiers and formulas for land tax. A big land tax bill needs to be provisioned for – you are negligent if you don’t consider it as part of your financial return.  
    • NT no land tax 
    • ACT trying to phase out land tax 
  • Why big corporations and Government are ideal tenants? Safer to get a government tenant or big corporation – they sign long-term agreements and they are a safer bet than getting in a video store or other retail stores.  
  • Warehouses and ‘warehousettes – the high-rise apartment segment of commercial property. Small commercial dwellings that allow you to warehouse on a smaller scale.  
  • Mitigate risk is by having flexibility – being able to convert your warehouse into something else. Normally warehouses have an open plan and can be refurbished for something else. Warehousettes would have a lower risk because you have a number of options – but bigger warehouses have less options. If you lose a person from your warehouse, they can go to a number of others. So, you may be vacant for a while.  
  • ‘Just in time’ to ‘Just in case’ – we will need more storage space – derelict industrial space that haven’t been used in decades, you’ll see warehouses be built on top of those. But location is still important – near the freeway, near train lines. It won’t take long to get into an over-supply of warehousing and long-term vacancies.  
  • Converted warehouses for residential – check the zoning, it could still be commercial or industrial. If the council says ‘no’, this is going to be a stumbling block. 
  • You get planning approval to change the land use or zoning of the area, so that you can convert it to residential. There is a lot to be said about having a dwelling in an older style building. 
  • If it’s a commercial property, it’s going to be a 60-70% lend, you need to get a building inspector to check plumbing and wiring, heritage check (it may restrict what you can do).  
  • If you’re converting the warehouse yourself, construction costs will blow out. They are very expensive and you get a myriad of surprises. You need to make sure you have a big buffer of cash to complete it. About two thirds of properties are owned by owner occupiers, a large percentage of those is a family. A lot of warehouses converted are not suitable for families, so you have risk when you go to re-sell it – owner occupier appeal and depreciation.  
  • Real estate investment trusts 
  • Opportunity where investors can buy a stake in property assets (including buildings and mortgages) without tying up their capital in the long term. REITs can be traded, like stocks, on major exchanges. Make up about 8% on ASX. 
  • Different types:  
    • Industrial trusts – warehouses, factories, and industrial parks. 
    • Office trusts – medium to large scale office buildings in and around major cities. 
    • Hotel and leisure trusts – hotels, cinemas and theme parks. 
    • Retail trusts – shopping centres and similar assets. 
    • Diversified trusts – a mixture of industrial, offices, hotels and retail property. 
  • Pros of REITs 
  • REITs offer access to the property market with professional investment management at a relatively low transaction and management cost. 
  • REITs can be bought and sold as quickly and easily as shares, so you can convert some or all of your investment into cash in as little as three days. 
  • REITs offer instant diversification and exposure to sectors of the property market you would not otherwise be able to access. 
  • REITs typically pay a higher yield (often 5-7%) which appeals to some investors.  And this rental income is generally more stable than the profits of a traditional business.  Also, this cash yield is unaffected by any changes to franking credits. 
  • REIT income can be tax-efficient.  Distributions often come with a ‘tax-deferred’ component, which means an investor will only pay tax on some of the income (this also reduces their cost base for tax purposes, resulting in higher capital gains tax later). 
  • Almost all REITs structure their leases to include mandatory rent increases each year.  This is either a fixed rate like 3% per annum, or it could be CPI inflation +1-2%.  This offers higher certainty around future earnings and income for the REIT and the investor. 
  • REITs are relatively low effort investments.  Not much changes from year to year, so there is generally less to worry about than shares in a typical business. 
  • Commercial real estate has huge economic value, and much of it is not available for investment on the stockmarket. 
  • Cons of REITs 
  • Market prices of REIT units fluctuate daily, and are subject to market sentiment as well as devaluations of underlying assets. 
  • Falling occupancy rates and increasing vacancies hurt revenues. 
  • Some REITs may borrow funds to increase potential returns. This gearing magnifies both returns and losses. 
  • Distributions (the income from the trust to investors) can vary over time. 
  • Rising interest rates hurt profitability. 
  • Sharp economic impacts can hit REIT’s liquidity such as the GFC or a global Pandemic. 
  • Private pros 
    • As listed vehicles, REITs can be affected by broader day-to-day share market movements. “The returns on unlisted trusts are less correlated to the share market so unit prices are less volatile and reflect undervalued assets,” 
    • In essence, unlisted property funds are the closest proxy to direct property investment – but with the benefit of professional management. 
  • Private Cons 
    • Capital locked in for duration of trust 
    • While the unlisted units cannot be bought and sold on market in the same way as a listed REIT, the funds usually ensure liquidity by holding a certain amount of cash (in some cases, liquidity is generated by selling assets). If you are selling, you may be required to sell to someone within the private REIT first.  
    • If you are worried about liquidity, this is not the asset class for you and you would be better off in a listed REIT. 
  • Listed pros 
    • Buy or sell at any time 
  • Listed cons 
    • Unit price can be volatile and imitate share market 

David Johnston- The Property Planner’s Golden nugget:  there is a real distinction between listed and unlisted, you must be significantly wealthy to take the risk of an unlisted REIT whereas a listed one you’re more likely to have a broader spectrum of investments in it and in a downturn more likely to be able to sell and receive income.  

Peter Koulizos – The Property Professor’s Golden nugget: check out our notes on the website, great tips when looking to purchase commercial property. Whether it’s residential or commercial property, location is the key. There are different location factors which are important when purchasing a warehouses, when compared to a shop or office. If you’re buying a group of commercial properties, the anchor tenant is very important. But by far the most important factor is the lease. The lease is the bible. If you can’t read and interpret it, pay a lawyer to do it to make sure that you understand what you are committing to.  

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