The fact is that institutions just don’t include residential property as part of their investment portfolio anymore, so why are we so focused on residential property?
While the fundamentals are the same, investing in commercial property is just a lot less forgiving. Guided by ‘soft’ needs like ambience and aesthetics, buyers of residential property are generally buying a home to live in. The primary market for homes is buying to live, with renting homes to tenants a secondary purpose. Commercial property buyers on the other hand don’t care much for the ‘soft’ stuff, but focus primarily on how much money the building can generate.
The actual buildings or improvements have little direct influence on the value, which is rather determined by how much rental it can earn. So income is everything.
Think of it, you can still buy stunning buildings in most of our major CBDs for a fraction of their replacement cost, purely because the rental potential is poor, but if your rental income is poor on your rental apartment, there is a buyer looking for a home who is not the slightest bit interested in the yield.
Finding the value
There are three methods most commonly used to value commercial property: income capitalisation, discounted cash flow, and construction or replacement cost. Income capitalisation is the current value of a property based on an annual return that would be acceptable to the investor.
How would we get to a value on a commercial property using this method? The basics are simple. Look at the leases and add all the net rental amounts for the year. Commercial leases almost always exclude all operating costs from the basic rental, so it’s easy to get to the net rental that you will put in your pocket. Decide what return (capitalisation rate or cap rate) you want to achieve, and divide the net annual income by this percentage and you will get to the value. A particular building in a particular area will trade at a cap rate based on previous sales in the area.
A blue chip long-term lease will increase the value of your building because a buyer will be satisfied to apply a lower return because of almost guaranteed cash flow or reduced risk, and of course lower return, or the longer the buyer is prepared to wait to get his investment back, means that he is prepared to pay more for the opportunity.
Residential vs commercial
Of course if rentals are everything, then remember that they escalate at not much more than inflation on the whole, so you might enjoy a 10% rental escalation during the course of the lease. If there are no other factors then your return is pretty static and unexciting, where you may argue that in residential property there are periods where capital values increase dramatically, pushed by market forces.
But the fact remains that you have little control over your speculative residential investment and the capital growth is almost entirely a factor of too many buyers chasing too little stock, whereas in commercial ventures you can extract value by other means that are within your own control. As an example you can increase the future income by investing in an upgrade which will attract better tenants, or add a rentable area by adding a floor, or enclosing an open area, or adding additional parking.
To illustrate with a personal example, a syndicate I was involved in recently bought a vacant building in Randburg, Gauteng for just over R3 million, invested a small sum in revamping common areas and sold it fully tenanted within three years for just over R11 million. The leases determine the value!
The funding gap
So why do we not follow the smart money? The fact is that banks are also aware that commercial property is more risky, and have to take into consideration that you may lose a tenant which will reduce the value of their security. So it’s harder to borrow money to fund a commercial property investment, and a larger deposit is required. It’s advisable to have cash reserves to cover a vacancy which may see you without income for an extended period.
Residential on the other hand is easier to get into, it’s easy to flip a non-performing residential property even without a tenant, and in certain circumstances the banks will lend you the full purchase price.
There is nothing wrong with building a portfolio of residential property, but ultimately commercial real estate is the place to be. Just watch the smart money.