Investing in real estate is a great way to build wealth, and investing in commercial real estate, in particular, provides higher returns than investing in residential property. While most first time investors in the property market opt for residential properties that offer lower but steadier streams of income from rent; commercial real estate investors are more well-versed in the vagaries of the real estate markets and more amenable to risk. Whether you want to invest in commercial property for self-use or rental yield, it is a decision which while not difficult, must be made after thorough research of the market in general and the selected property in particular.
Types of Commercial Properties
The two most common types of commercial spaces available are Offices and Retail outlets. These are the most popular choices for commercial investors because there is usually a high demand and consequently good return on investment. Industrial spaces (warehouses, manufacturing sites, industrial buildings etc), Multi-family spaces (entire apartment blocks, condominiums etc) and Special Purpose spaces (schools, hotels, hospitals, stadiums etc) are examples of large commercial spaces that attract large institutional developers as opposed to individual investors. For the purpose of this article we will concentrate on Office and Retail spaces.
- Office – By far the most common type of commercial spaces, these can range from a single-tenant office to an entire building with multiple tenants.
- Retail – The second most popular type of commercial spaces that include single shops to entire malls! Restaurants, banks etc also fall into this category.
Commercial Space Checklist
Demand vs Supply – Demand vs Supply analysis is extremely crucial while selecting the location. Every city has within it, micro-markets – desirable clusters of commercial spaces that can be considered premium investments. In Bangalore for example, office space along the Outer Ring Road, Whitefield and Electronic City environs can be considered a ‘sound’ investment – one that will offer good return on investment. In Mumbai, one might consider BKC, Parel or Nariman Point. Every market has a unique demand-supply dynamic. Large brokers like JLL, Knight Frank etc. publish annual demand for commercial spaces that can be studied before committing to any investment. If supply exceeds the estimated demand over a few years, property prices and rents are liable to fall in both new and old properties.
Location – Since commercial spaces provide income through rent and capital appreciation both of which are heavily dependent on location, location is key! Look for locations with a vacancy rate of < 5%. A high vacancy rate means, tenants can move and/or negotiate lower rents.
Market Rent vs In-Place Rent – Investors must research ‘current’ rental rates being offered in the location of their choice. This is the rent that most tenants will be comfortable with. Higher than market-rate rentals can make tenants keen to renegotiate and even vacate properties that they see as over-priced.
Design & Construction Quality – A well-designed and constructed space will rent faster and attract a better quality of tenant. Needless to say it will also fetch higher rents, better tenant retention and higher capital appreciation.
Interiors – Offices in India are generally delivered as empty spaces without any interiors done. Interior fit outs include flooring, ceiling, air conditioning, electricals, work stations etc. which can be done either by the tenants themselves or the developer who charges an additional fit-out rent. The cost generally works out to between 800 -1,000 Rs./sq. ft. and developers charge between 300-360 Rs./sq. ft. annually. If a tenant has done their own fit outs, they are likely to stay longer to recover costs.
Base Rent vs Fit out Rent – Developers may often try to increase property costs by quoting fit-out rents. Investors should understand that fit-out rents while applicable are NOT permanent. They are usually payable over a fixed period of time (5 years) and stop thereafter. Investors should take this into consideration, if developers quote a higher price initially, promising higher returns and remember that this is only a temporary gain.
Security deposit – Security deposits in commercial properties vary between 10 and 12 month’s rent. If tenants offer a deposit of 6 months or less, it might mean that they have cash flow issues or are only looking at short-term occupancy. Startups also tend to prefer smaller deposits and shorter lock-in periods.
Lease structure – Commercial leases are structured very differently from residential ones. They are generally structured as 3+3+3 or 5+5+5 meaning 9-year or 15-year leases with provisions for escalations every 3 – 5 years. They also tend to favour the tenant in that they can vacate at any time whereas the landlord cannot ask them to leave for the lease period. However a lock-in period (generally 3 years), in the lease, means that the tenant cannot vacate during that period and so offers some protection to the landlord. Longer lock-ins are beneficial to the investor.
High Quality Tenants – A good tenant – one who pays rents on time, pays higher deposits, and stays longer – can significantly increase the value of a commercial property. Blue-chip multinationals make some of the better, more desirable tenants.
Advantages of Commercial Space Investing
|Commercial Spaces||Residential Spaces|
|Higher initial investment costs with 6 – 12% return on investment.||Lower initial investment costs with 1 – 4% return on investment.|
|Longer leases and low tenant turnover.||Shorter leases and high tenant turnover|
|Steady cash-flow due to longer leases and tenants often picking up property taxes as well as insurance and maintenance costs.||Payment of maintenance costs must be negotiated separately with each tenant. Property taxes and insurance costs are born by the owner.|
Investing in commercial space is not difficult but requires thorough research and planning into the various factors that affect the commercial real-estate market, mainly, location, local job market buoyancy, infrastructure initiatives and migration patterns; some of which are out of investor control and contain more risk than others. It is advisable for investors resist the lure of a ‘fast buck’ and take their time before rushing into unwise commitments of what can be a volatile market.