Many commercial property investors often fail to optimise their portfolios by overlooking some very basic asset management fundamentals. So what are some of the key areas that can help boost returns from commercial property and why are these often missed by do-it-yourself investors?
In Part 1 of this article, we looked at the effects of debt, statutory costs, variable outgoings and lease renewals. We now take a look at the fundamentals of rent reviews, depreciation, and planning or zoning changes.
5. Rent reviews
Most investors understand the basic concept of rent reviews; as a general rule they are applicable on an annual basis for commercial property by way of CPI, fixed or market review.
CPI and fixed reviews are relatively simple to understand and implement. Market reviews are more complex and can vary substantially subject to what is agreed in the lease.
When purchasing a leased asset, it is important to understand the market review mechanism to assess the potential for rental growth or perhaps even rental reduction. For example, many commercial leases have ‘ratchet’ clauses to prevent rents falling (save tenancies subject to the Retail Tenancies Act), which can help maintain the rent in a falling market until lease expiry.
Conversely, it is not uncommon for market reviews to take into account market incentives. In softer markets, it’s not uncommon for incentives to be more substantial which, if a market review was to account for this, could lead to a substantial decrease in the rent payable by the tenant.
The DIY investor needs to examine the lease carefully when buying a property and indeed when leasing to tenants. Increasingly, larger tenants are appointing tenant advocates who are adept in negotiating market reviews in leases. Property funds are similarly well versed in negotiating these clauses and knowing the effects they have.
Many DIY investors will be familiar with tax depreciation. It is a complex subject, but in simple form, the building’s depreciation can be offset against the net income to reduce the income tax payable.
This does pose some ramifications for Capital Gains Tax (CGT), however, as property is typically held for a longer term – usually more than 12 months – the ultimate CGT is generally subject to a 50% reduction.
For larger assets in a property fund, the build costs are often higher and have a significant depreciation value. Additionally, the plant and machinery are often more substantial and depreciate at a higher rate due to their lifecycle, offering increased tax benefits.
It is wise to consult with accountants and depreciation experts on these matters, as both DIY investors and property funds can benefit from depreciation. As a very general rule, however, the larger-value commercial assets in property funds can benefit from increased tax deferrals.
7. Planning, zoning & encumbrances
All land or properties are subject to zoning and planning requirements. Many properties fall within a local development framework with clear zoning that is relatively simple to understand. However, even properties that comply with this framework may unwittingly be in breach of the development application. Development conditions have become increasingly detailed and there are usually numerous conditions to a development consent.
By way of example, during a recent property purchase, a condition of development was to ‘underground the power cables’. Upon physical inspection, all power cables on the site were underground, however the street power cables were overhead. The wording of the condition was not entirely clear, but further investigations with the local authority returned that the street cables were required to be moved underground, posing a potentially significant cost to undertake. The condition was only uncovered through comprehensive due diligence, and a less-diligent purchaser may have purchased the site without knowing this planning condition was outstanding.
Another pitfall to be mindful of is highway reservations. Many commercial properties on main carriageways can be subject to further development of the highway, which can impede development on all or part of a site. If purchasers or owners are unaware of a highway reservation, they may not realise the effect on potential development until the highway proposal becomes reality or they seek development approvals.
The above examples are only a small part of the extensive topic of planning and zoning. Ultimately, investors need to be conscious of where their asset sits and what effects or encumbrances the planning framework has upon it. Property funds commit time and money to thoroughly investigate the position of both existing frameworks and also any changes that are made to them, a process that can be very costly and time consuming for the DIY investor.
8. Other matters
One of the newer aspects to commercial property is sustainability, an area that is only going to grow. Energy efficiency information has become a legislative requirement for commercial offices, for example, where space over 1,000sqm is offered for sale or lease. This mirrors the requirements of many other countries around the world and will, in our opinion, increase in commercial property over time.
Aside from the legislative requirements, there are genuine savings to running costs that can be generated. LED lighting upgrades can substantially decrease electricity costs, and there are several practices developing for more efficient air conditioning. Metering services and tendering electricity costs are also helping to reduce running costs, not to mention the ability to provide solar power to further enhance this.
These initiatives, and many others, can assist in driving down running costs for tenants, which in turn can lower the overheads for running the property, resulting in the potential for an increase in rent to the investor’s pocket.
Investors need to be mindful, however, of the capital cost to realise these savings (for which there are depreciation benefits) and that often economies of scale result in the efficiencies being more viable on larger assets.
While we have covered some key asset management fundamentals in this article series, there are many more. For a DIY investor to maximise their portfolio there is a great deal of understanding required in keeping abreast of all the factors that may impact their investments. While most private investors are capable of undertaking this, the time cost can be considerable. Without the appropriate time allocated, a great initial commercial investment can quickly become an underperforming asset.
An alternative option for commercial property investors is to invest in a pooled investment structure like a professionally managed property fund. To find out more about property funds, visit our commercial property funds page.