Many commercial property investors will 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?
Anyone with the financial capacity can become a commercial property investor, but few have the expertise or the time to adequately manage their assets, let alone find a commercial property that will deliver superior returns.
Even with the assistance of a property manager, the onus can often fall on the DIY investor to ensure returns are optimised.
In part 1 of this 2-part article, we examine four ways to optimise commercial property assets to deliver higher returns to investors.
1. Debt
Most investors will gear their commercial property to assist in purchasing an asset or to boost returns in low-interest environments.
Whether fixed debt or variable, rates are for limited periods and it falls on the owner to be aware of renewal dates and to secure the best rate for the next period.
The closer you are to the market the better chance you have at optimising your debt structures by deciding when to fix or when to remain on a variable rate.
Property funds generally achieve a better rate than the DIY investor simply because of the economies of scale (as funds can borrow more to buy larger assets) as well as access to commercial industry rates.
Additionally, the loans in property funds are generally unsecured so there is no exposure to the individuals within the trust, whereas the DIY investor will have to provide security over the asset, and possibly other assets in addition.
2. Statutory costs
For land tax, council rates and other statutory costs there is an underlying property valuation.
It is not uncommon for professional property managers to have never challenged the underlying valuations and, dependent on the property management contract, it may not be a requirement for them to do so.
However, if the values aren’t tested and challenged, the DIY investor could well be paying more than necessary for statutory payments on their commercial property.
This isn’t uncommon. Typically, the relevant state body responsible for commercial property valuations will simply apply a rate dependent on the square meterage of the asset as well as the asset type.
This is, however, often too simplistic as all commercial properties are different. There may be an easement on the title or a restriction on development that affects the value, for example.
Therefore, it’s up to the DIY investor (or their property manager) to challenge these, and the savings can be significant. Even if the costs are recovered from the tenants through the outgoings, the lower the outgoings to the tenant, the better the share of gross rent to the trust.
In a property fund the manager should be very aware of valuation processes and is able to constantly review the valuation basis and challenge these as applicable.
3. Variable outgoings
For the DIY investor there is generally a reliance on the property manager to control the outgoings and the billings to tenants.
A good property manager should be capable of handling this efficiently. However, has the property manager interpreted the lease correctly to ensure all outgoings are recovered?
Most commercial leases are prescriptive on the recoveries of outgoings and in certain property sectors legislation also dictates what is recoverable; however, often they can be open to interpretation and this needs to be properly considered.
Additionally, has the property manager challenged the cost of the service providers and have you benefited from reduced rates from the size of the portfolio they manage?
A DIY investor really needs to be challenging their property manager on all these items, but again this takes time and an understanding of what needs to be challenged.
Property funds are dealing with these issues every day and continually identify areas of inefficiency and errors on recovering costs.
4. Options and renewals
In a tenant’s market, who is ensuring the tenant is happy enough to want to renew their tenancy or serve their option?
When approaching a lease expiry, it’s prudent in a tenant’s market to ensure that repairs and issues are resolved more speedily and efficient than ever in order not to detract from the property.
Additionally, in a competitive market, agents and other owners could well be speaking with your tenants offering alternative premises particularly if they are aware a lease expiry is approaching.
It’s prudent to be on the front foot and make contact 12-18 months prior to an option or lease expiry.
Consider offering them a proposal as it is more than likely they are looking at or have been presented with other options. If they know you are prepared to meet the market, it may go a long way to securing them on renewal.
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.
6. Depreciation
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.
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