All Topics / Commercial Property / Making Money Out of Commercial Property $$$

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  • Profile photo of Chris WhiteChris White
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    @chris-white
    Join Date: 2006
    Post Count: 65

    Hello everyone, 

    Thought I would make a contribution to the new commercial property section of the forum. This information may be common knowledge for some however, could be a good starting point for those new to commercial property. 

    Commercial property is great! I have done renovations, property development, subdivisions and buy and hold however, in my opinion, there nothing better than finding a commercial property where there is upside rental potential and/or potential to improve the lease structure or tenant quality. 

    Increased rent capitalized by the areas capitalization rate = equity  

    I am writing this post in between my two year old and new borns sleep so I will elaborate on the more technical terms and examples of capitalizing increased rent to increase your equity in another post.

    ______________________________________________________________________________________________
     
        

    Making money out of commercial property! 
     

    I use the phrase ‘commercial property’ in the broader sense, encompassing Office, Retail, Industrial, Hotels etc. 

    Commercial property investors may consider a wide range of property types and yields. Investors should think carefully about what type of commercial property investment will suit them and indeed what risks they are prepared to take for a higher return. And indeed will higher yields deliver higher returns?  

    Investing in commercial property 
     

    There are many variables to consider when buying commercial property, for example;
      

    Type of tenant: 
    Properties with less established or smaller tenants may offer investors higher yields. It is suggested that a 6 month bond is appropriate for a property with smaller tenants. I.e. if a tenant goes bust, it may take 6 – 12 months to replace them.   

    Lease term:
    Investors usually expect to buy commercial property on a higher yield to compensate for a shorter lease term. (I.e. to reflect the risk of a potential vacancy should the tenant leave). On the other hand, if market rents have increased since the last rent review, there may be an opportunity to increase the rent at the expiration of the current lease term. In this case investors may be more receptive to buying the property on a lower yield and a shorter lease term, knowing that they can increase the rent in the short-term and therefore benefit from an increase in the property’s value.  

    Supply & Demand:
    A commercial property may offer a higher yield if there is a great deal of new property supply on the market. Increased supply means tenants have more properties to choose from, which may cause rents to reduce down the track and mean landlords having to offer more incentives to attract them. This scenario may reduce the value of your property.  

    Location of property: 
    Properties in remote areas which lack proximity to infrastructure and transport nodes or have inferior exposure may be bought on higher yields (to reflect the potential longer vacancy periods should the tenant leave).   

    Age of the property: 
    Older properties often require more ongoing maintenance and may therefore offer a higher yield to the investor to compensate for the extra costs. These extra costs can erode the investors return if they do not forecast them accurately in their due diligence period. A detailed inspection and expenses forecast by a facilities management company can help mitigate the risk of underestimating future costs. 

    Lease structure:
    Often with commercial property the tenant will pay for the outgoings however, it is important to check (and have a solicitor check) the lease thoroughly to ensure that there are no surprises. Smaller tenants will usually not cover outgoings such as land tax, management fees and replacement costs of a capital nature (for example a/c). For strata properties also check who pays for the gardening, rubbish removal and toilet cleaning etc.   

    Cost of vacant property: 
    When a property becomes vacant you will obviously still have your interest costs to pay. To attract a new tenant you may also have to offer them incentives, such as a rent free period and/or a contribution to their fit out. Typically incentives can equate to 6 months per 5 year lease term. So if it takes 6 months to find a tenant, you may have to add another 6 months worth of costs to this to get the tenant in the property.   

    Properties with higher rental returns (or yields) may or may not always provide the best overall return.
     In my experience a lot of commercial properties advertised for sale fail to mention a lot of the hidden costs and ‘upside’ too.

    It is up to the buyer to do their due diligence thoroughly.  The good news is that most investors stick to the residential market so that leaves great opportunity for us commercial property investors.  

    Sorry if I have bored some of you with this long post – commercial property excites me. 
      

    Commercial Property Case Studies

    Chris White | Pillar Property
    http://www.pillarproperty.com.au/
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    The Property Investment Specialists

    Profile photo of DexterJamblesDexterJambles
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    Thanks for the post Chris.

    A good starting point for people like me with no experience or exposure to commercial property but who maintain an interest and intention to make the move to commercial investment in the future.

    Profile photo of erikkoerikko
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    in rentals alone that makes a lot of money specially if the commercial property is feasible in any kind of market

    Profile photo of AimHigherAimHigher
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    Chris

    Thank you so much for sharing your wisdom!  We're in the research stages of property investment and commercial property is something I've just started to look into.

    Your information is invaluable.  We have a lot more to learn before we decide on the course of action that's right for us and your post has really lifted things.

    Thanks again

    Profile photo of DaedalusDaedalus
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    Hi Chris,

    Thanks for your post. I'm interested in the idea of renovating commercial property to increase the rent – therefore the value.

    With residential renos there are some pretty standard items such as kitchens and bathrooms that can have big bang for the buck – are there similar areas of focus for commercial renovations?

    Also, I assume that the revaluation is dependent on the actual rent increasing, which means taking advantage of the part of the lease that allows rent to be determined based on market value? How does this part of it work to release the equity?

    Cheers

    Daedalus

    Profile photo of Chris WhiteChris White
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    The objective of a commercial renovation or improvement is similar to residential property, i.e. the property should be brought up to an appropriate standard so it appeals to prospective commercial tenants and/or prospective purchasers and one should not over capitalize the property.  

    The requirements of commercial tenants will vary depending on how they will be using the property i.e. whether it is for an office, retail or industrial purpose. As with residential property the requirements and tastes of commercial tenants and buyers will vary, so you should stay neutral with the improvements, otherwise a tenant or buyer may walk in and want to completely change what you have done. The improvements should be from practical perspective and increase the potential of attracting more rent.  

    Market research will tell you what improvements will draw tenants and what the ceiling rents are for similar properties in the area. You do not want to spend money on things that will not contribute to being able to increase the rent. (We often ask local valuers in an area what the rental ranges are for various types of properties).   Some typical things that could increase the rent and improve the value of the property are; 

    • ‘Clean it’
    • Mezzanine level (add more floor area & rent it out at a rate per sqm)
    • Add an office
    • Add internet and telephone connections
    • Awning
    • New floor covering
    • A/C system
    • Suspended ceiling
    • Grease trap
    • New plasterboard walls + paint
    • Fit-out per tenants requirements
    • Remove walls or add walls (partition walls are easy to add and remove)
    • Create new entry and exit ways

      Sometimes it is best to just tidy up the property and repair / replace the basics and offer the new tenant a fit-out in lieu of increasing their rent. (Or your existing tenants may ask you to spend money on the property in lieu of a rental increase).  

    For example

    Say you offer to pay $50k in fit-out costs for an incoming tenant or existing one, and the tenant agrees to pay an increased rent of $25sqm x 250sqm (of floor space) = $6250 per year. At a capitalisation rate of 8% the increase in value would be $6250 ÷ 8% = $78,125.

    We would consult with a local valuer before spending a cent to gauge what the potential lift in value would be. (I.e. maybe the cap rate in that area is 7%, which would improve the value by more than $28k). 

    You may want to achieve an increase of more than $28k in value to make the exercise worthwhile however; this is an example. Of course you might also be able to depreciate the $50k in improvements which then starts to really improve your cash flow.  

    So even if your loan repayments were 10% x $50k = $5k per year you would be +ve cash flow on your expenditure + have further depreciation deductions.  Obviously if an existing tenant approaches you mid way through the lease requesting such improvements you would have to do an amendment to the current lease. 

    We recently negotiated with an industrial tenant to build them a further 500sqm of warehouse space at a costs of approx $500k.  

    This attracted a further rent of 500sqm x $110 per sqm = $55k. So will increase the value by $687,500 (55k ÷ 8%). So even after interest repayments we have increased the +ve cash flow and also increased equity.  

    Hope this helps.

    Chris White | Pillar Property
    http://www.pillarproperty.com.au/
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    Profile photo of Chris WhiteChris White
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    @chris-white
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    Post Count: 65

    The objective of a commercial renovation or improvement is similar to residential property, i.e. the property should be brought up to an appropriate standard so it appeals to prospective commercial tenants and/or prospective purchasers and one should not over capitalize the property.

    The requirements of commercial tenants will vary depending on how they will be using the property i.e. whether it is for an office, retail or industrial purpose. As with residential property the requirements and tastes of commercial tenants and buyers will vary, so you should stay neutral with the improvements, otherwise a tenant or buyer may walk in and want to completely change what you have done. The improvements should be from practical perspective and increase the potential of attracting more rent.

    Market research will tell you what improvements will draw tenants and what the ceiling rents are for similar properties in the area. You do not want to spend money on things that will not contribute to being able to increase the rent. (We often ask local valuers in an area what the rental ranges are for various types of properties).

    Some typical things that could increase the rent and improve the value of the property are;

    • ‘Clean it’
    • Mezzanine level (add more floor area & rent it out at a rate per sqm)
    • Add an office
    • Add internet and telephone connections
    • Awning
    • New floor covering
    • A/C system
    • Suspended ceiling
    • Grease trap
    • New plasterboard walls + paint
    • Fit-out per tenants requirements
    • Remove walls or add walls (partition walls are easy to add and remove)
    • Create new entry and exit ways

    Sometimes it is best to just tidy up the property and repair / replace the basics and offer the new tenant a fit-out in lieu of increasing their rent. (Or your existing tenants may ask you to spend money on the property in lieu of a rental increase).

    For example

    Say you offer to pay $50k in fit-out costs for an incoming tenant or existing one, and the tenant agrees to pay an increased rent of $25sqm x 250sqm (of floor space) = $6250 per year. At a capitalisation rate of 8% the increase in value would be $6250 ÷ 8% = $78,125. We would consult with a local valuer before spending a cent to gauge what the potential lift in value would be. (I.e. maybe the cap rate in that area is 7%, which would improve the value by more than $28k).

    You may want to achieve an increase of more than $28k in value to make the exercise worthwhile however; this is an example. Of course you might also be able to depreciate the $50k in improvements which then starts to really improve your cash flow.

    So even if your loan repayments were 10% x $50k = $5k per year you would be +ve cash flow on your expenditure + have further depreciation deductions.

    Obviously if an existing tenant approaches you mid way through the lease requesting such improvements you would have to do an amendment to the current lease.

    We recently negotiated with an industrial tenant to build them a further 500sqm of warehouse space at a costs of approx $500k.

    This attracted a further rent of 500sqm x $110 per sqm = $55k. So will increase the value by $687,500 (55k ÷ 8%). So even after interest repayments we have increased the +ve cash flow and also increased equity.

    Hope this helps.

    Chris White | Pillar Property
    http://www.pillarproperty.com.au/
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    Profile photo of Asian spiritAsian spirit
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    @asian-spirit
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    Hi Chris

    Thanks for the advice, we are currently looking into another commercial property, but i still have trouble getting my head around some of the fact and figures of it all, your last post did make good sence, but where did you calculate the $28k from?

    Cheers
    Gary

    Profile photo of Chris WhiteChris White
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    @chris-white
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    “Say you offer to pay $50k in fit-out costs for an incoming tenant or existing one, and the tenant agrees to pay an increased rent of $25sqm x 250sqm (of floor space) = $6250 per year. At a capitalisation rate of 8% the increase in value would be $6250 ÷ 8% = $78,125”.

    Hi Gary,

    The $28k is the difference between what you spent on the fit out ($50k) and the uplift in value ($78k).

    So the return on investment (ROI) is $28k ÷ $50k = 56%. Not a bad return for about a months work. Obviously, this increase is ‘equity’ as opposed to cash.

    To understand how you increase the value of commercial property you need to understand the capitalization method of valuation or income method.

    I can explain this in further detail if you want me to?

    Chris White | Pillar Property
    http://www.pillarproperty.com.au/
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    Profile photo of Scott No MatesScott No Mates
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    On the other hand Chris, the incentive is just that, an incentive to lease the premises: consequently, you kick the can for $50k but do not get an increase in the rental (unless it is for a sitting tenant) ie you are effectively dropping the long term rent on the property. It is used as a sweetener to get the tenant to agree to the rent that you are asking.

    Generally you would be seeking full repayment of the value of the incentive during the term of the lease plus some return on the capital invested. Therefore you would be looking at a much higher increase in rent eg: 5 year term on same basis would need a rent increase to cover the incentive of $11.5k (including a 15% return on your capital invested) or $46 psm. On a 3 year term term this is in excess of $19k pa ($76psm).

    A rent increase of $6250pa will take 12.5 years to be paid off (excluding interest) – the fitout is only good for the life of the tenant ie 3-5 years so you will effectively have lost between $19 & 31k should there be the normal make good requirement on the fitout. 
     
    Other considerations would include the ownership of the fitout at the end of the lease ie if the tenant renews has the ownership & liability of the fitout been transferred to the tenant upon expiry of the previous lease? Who has the benefit of the depreciation during the currency of the lease?

    As the cap method is one of the methodologies used it will reveal an increase in the property value however the skill lies in determining the appropriate cap rate having made adjustments for incentives in the lease ie you cannot look at the rent on face value and plug it into the formula.

    Hence you need a good understanding of the effects of the incentives that you provide (without me having delved into the legal or tax ramifications of the incentives).

    Profile photo of Chris WhiteChris White
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    They are good additional points that you raise.

    If you were going to spend money on a fit-out you would certainly want to be confident that your tenant was going to be there for the long term and/or you retained the ownership of the fit-out, depreciated it and could even leave the works in place for the next tenant to use. As such the nature of the improvements would have to be appropriate.

    A fit-out (term used in the broad sense) could include a/c, floor coverings, paint etc, so the ownership could be retained by you and be depreciated.

    Appropriate research would need to be done to ensure that the capital expense was not wasted and certainly you would not want to ‘kick the can for $50k’ and have your tenant leave in five years and not be able to re-use the fit-out.

    We always consult with local valuers to get a ‘projected valuation’ before undertaking any such exercise. You don’t have to guess with commercial property, you can negotiate any works ‘subject to’ adequate terms and rent and also ensure that your uplift in value will allow you reuse equity and/or sell your asset for a profit.

    My 2nd example of $200k profit would work better for this.

    Commercial property is certainly not for the inexperience and I would suggest a lot of research before investing in it for the first time.

    Our due diligence checklist has over 40 check points on it; many years of buying commercial property teaches you a few things.

    Chris White | Pillar Property
    http://www.pillarproperty.com.au/
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    Profile photo of songyokisongyoki
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    Thank you Chris, Scott.  I've learned alot today.

    Profile photo of PosEnterprisesPosEnterprises
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    yeah keep up the education, I am still learning about it.  There is a bigger risk buying commercial than residential isn't there? especially if the tenant takes off and you have to wait a while for a new tenant.  How much capital should you have behind you just in case.

    The deposit is usually 30% is that correct and then borrowing costs etc and how do you work out the yield and how it is going to pay the mortgage.  Would you pay interest only or P & I on this commercial loan.

    thanks for any advice

    Profile photo of Scott No MatesScott No Mates
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    Essentially you work with net yield. ie You need to know that Gross rent = net rent + outgoings; passing yield = initial net rent/purchase cost; theoretical yield = fully let net income/purchase cost, current yield = net income/curren market value.

    Profile photo of PosEnterprisesPosEnterprises
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    When would a good time be when purchasing your first commercial property. would you wait until you had a few residential properties behind you or just wait until you had a good deposit and buffer to make sure you could handle it.

    Is there any decent websites you can explore which show what is fair that you are paying? like RP Data?

    Profile photo of Chris WhiteChris White
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    You definitely need a buffer when investing in commercial property. You need to be able to ride through potential vacancy periods and/or capital costs (especially with older properties).

    I am sure that most commercial investors will agree that 'right now' I am seeing some of the best buying opportunities for several years. I expect this to continue for the next 6 months.

    Good commercial assets that are being sold on great yields from motivated vendors do sell quickly though.

    My advice is to spend as much time as possible getting across commercial property so you will recognise a deal when you come across it.

    See some commercial case studies – yields are pushing to 9% now for good properties

    http://www.prospergroup.com.au/commercial-property-buyers-agents-case-study-sub.html

    Chris White | Pillar Property
    http://www.pillarproperty.com.au/
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    Profile photo of PosEnterprisesPosEnterprises
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    Thanks again Chris where can you learn about investing in commercial property in the real world.  What courses or books do you suggest reading to get the information so you have an understanding when negotiating with vendors etc.

    Profile photo of Chris WhiteChris White
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    Do you mind sending me an e-mail [email protected] and I will respond with suggested reading.

    I would prefer to refer books privately.

    Thanks

    Chris White | Pillar Property
    http://www.pillarproperty.com.au/
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    Profile photo of PosEnterprisesPosEnterprises
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    Hey Chris sent you an email but not sure if you got it or not.

    Profile photo of Chris WhiteChris White
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    Hi, yes got your e-mail and sent a reply however it bounced back to me twice – not sure why?

    Do you have another e-mail address?

    Chris White | Pillar Property
    http://www.pillarproperty.com.au/
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