Commercial yield higher but riskier

10-09-2007 | Joanna Grigg

Commercial properties have two big pluses. They can deliver higher yields than residential and lessees usually take responsibility for decoration and maintenance.

Speaking at the Marlborough Meat & Wool Monitor Farm Field Day in August, valuer Lex Hayward compared commercial and residential property investment.

Using five recent Blenheim sale examples from 2007, Lex showed that commercial property was delivering rental returns of between 6-8% on investment. For example, a CBD retail property (with two shops) that sold for $760,000 had a lease agreement that gave a 7.81% gross yield from rent.

Any increase or decrease in property value over time is then added to this yield figure. If property prices grew 5%/year, then the total gross return would be 12.81%/year less costs. However, if property prices came down 5%/year, then the return would be only 2.81%/year. This could leave investors seriously out-of-pocket if they had to sell on a low and they had borrowed money at 10%.

Inflation of two percent per year, costs and tax should be offset against returns as well.

Commercial buildings are more affected by economic swings than residential property so the risk of lower or negative yields are greater. For this reason, Lex suggests that property investors should target a 7.5% gross return from rent of the property plus factor in a 0.3% ‘risk premium'. This means that the property rental return should be around 7.8% of the price paid. Table A shows an example of the income capitalisation process.

One option for setting sale price is using a ‘discount cashflow' process. This is when the rental income stream is used to fix a value on the property. The income over ten years, for example, is taken into account and a sale is assumed at the end of the period.

"It is an actuarial calculation, that gives you a value for the income over time for that investment."

This is used for multi-tenant properties or to reflect more complex income streams. The discount rate is derived from sales analysis.

Commercial property has higher entry costs so there is often less competition for buyers. Most sell for well over $500,000. Good equity is required, with the maximum amount that banks are prepared to loan sitting around 60-70% of the total value. In comparison, banks are often prepared to loan up to 90-95% of residential property investments.

An advantage is that lessees are usually long term, meaning less hassle searching for new tenants. With Marlborough's high growth rate, Nelson and Christchurch investors have been active in buying commercial property.

"They are buying an income stream," says Lex.

If starting out in on-farm property investments, Lex advises farmers that they invest very carefully.

"If you want a foolproof investment, put your money in the bank.

"Research the market and analyse returns."

Once you've made the purchase, manage the property. Expertise in this area can be bought.

"The lease agreement is the ‘bible'."

Lex also suggests not to rely on sale information provided by the vendor. This can change over time so practise due diligence by getting things checked by an independent source. This is when valuers are useful.

Lex went on to give examples of potential yields from Dunedin residential ‘student flat' properties, something he has invested in himself.

Over 19 properties put on the market in 2006 and 2007, the asking price to rent ratio gave a potential gross yield of 5.76%/year. Any increase in property prices would be on top of this.

One High Street property owner was asking $275,000 but it had seven bedrooms so could gross $34,580/year. This is a 12.6% return. Rates would need to be taken off this gross figure.

Lex considered a gross rental yield of 5-6% per year to be pretty low. After tax and inflation this may only produce a 2% real return.

He outlined how some properties had potential to be revamped and rents put up.

One basic Dunedin North property retailing at $305,000 would return 6.82% when rent was set at $80/week (see photo). Renovations had the potential to increase rental returns. Expenses for both residential and commercial property were tax deductible.

One drawback to developing a property is the lack of time farmers had to commit to renovation projects.

If a farmer's own sheds and house are in need of repairs and maintenance, it may be unrealistic that a ‘do-it-yourself' job is possible. On the other hand, paying tradesman may still be cost-effective.

Tenants can be difficult to manage. Lex has a twenty-dollar rule when deciding when to lease or rent a property.

"If I felt I could loan someone $20 and expect to get it back, I would let them rent my property."

Lex says the golden rule of investing in property is to weigh up whether the location is desirable.

Lex believes that yield (return on rent) is vital for an income stream.

However, location is important for capital gain and when downwards pressure comes on property prices.

Taking the time to look at different properties is considered vital to get a handle on location and the type of investment that suits an individual.

When considering a property, things to take note off include boundaries, easements, covenants, mortgages, building permits and resource consents, rights of way, chattels, business activity consents, zoning, Maori land rights and plantings.

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