Know your commercial property

Non-residential spaces are marketed as high-return investments, but pose higher risks

When the housing property goes on a downtrend, you often find commercial properties such as retail shops, office spaces and warehouses pitched as great alternatives. HNIs and NRIs are lured to buy office or retail spaces (individually or pooled). There are also fractional property ownership options, to get a slice of the larger commercial property action.

But before investors jump in, they must understand these properties are very unlike residential properties.

Chalk and cheese

For one, homes or plots are often bought for capital gains from price appreciation; rental yields are low. However, the key selling point for commercial assets is the recurring income — typically 6-12 per cent — from rental. Price appreciation tends to be modest.

Two, the risk profile is also very different. Typically, residential real-estate prices are not co-related to the equity and debt markets — no matter how the economy is, there is end-user-driven demand for homes.

But commercial property returns are related to the economic cycle — rents increase as demand picks up and vacancies shoot up when there is a slowdown. It is also more illiquid and hence riskier.

Three, you typically need a smaller investment for residential property. For example, a 1,000 sqft 2BHK home may be available for, say, ₹50 lakh in the suburbs. But a similar-sized shop may cost well over ₹1 crore. One reason is that they tend to be in prime locations. In the case of office spaces, they are usually large, needing higher investment.

Four, loan terms are different. For instance, you may pay 20 per cent as down payment while buying a home. In case of commercial assets, the maximum loan you can get is only 60 per cent of the asset value; so upfront payment is higher. The interest rates also vary based on the risk assessment, including on the property — 1.5-5 per cent higher than home-loan rates. There are also no tax benefits available on commercial property loans.

Five, maintenance costs, taxes and other overheads tend to be higher for commercial property, compared with homes. This is because there is more wear and tear. Tenants also expect better upkeep for their rent. So owners must budget for this and line up resources to ensure good upkeep.

Six, often a home or plot may be bought with some immediate or long-term self-use in mind. But commercial properties are typically seen as an investment. The knowledge level needed is also higher, and hence it may not be suitable for many investors.

Emerging trends

If you do want to invest, there are a few trends that may impact your investment return. For example, office spaces may be losing lustre with the advent of co-working spaces. These are gaining popularity as a good replacement to small office spaces.

Small retail spaces, on the other hand, may see demand growth. For one, e-commerce players such as Myntra and Urban Ladder are opening brick-and-mortar stores.

Also, financial and other service providers prefer many smaller branches to get better footfall. These will continue to drive demand for small spaces in prime locations.

Another trend is growth of retail space beyond the metros. Many brands are shifting to tier II/II cities as there is good demand. Data from a JLL report on Retail Revolution shows smaller cities received an investment of $6,192 million during 2006-2017, while metros got $1,295 million in that period.

What to watch

As returns are mainly from rents, you must ensure the rental yield is good — over 10 per cent. This will give you 6-7 per cent after expenses and accounting for vacancy periods. Also, opt for a property that already has a tenant on a long-term lease. This will provide cash-flow visibility. The typical investment horizon is over five years, and you must invest only if you are willing to do it for the long term.

Only invest in quality buildings in central locations, even if you pay a premium price.

This is because vacancy risks are lower for high-grade property. Tenant profile will also be better, reducing issues regarding rent payment and maintenance.

Be cautious when you buy a portion of a larger building with multiple owners. Your rents and sale value will depend on the performance of the overall property. Poormaintenance may dent your returns.

The author is co-founder, Rana Investment Advisors.

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