One of the strongest benefits of investing in commercial property is the ability to add value to the property to increase its worth.
This aspect alone is what makes commercial so lucrative and sets it apart from its low-yielding counterpart, residential.
If you’re looking to maximise your commercial property returns, here’s four key things to consider:
One way to slowly build capital in a commercial property is to simply allow the rent to increase over time. If you are negotiating the lease yourself, this could be an opportunity to add value at a faster rate.
Most leases have an annual scheduled increase built into them and as the rent grows, so does your commercial property’s value. There are a few options for annual rent reviews. You can set them to coincide with the CPI (Consumer Price Index), which is the most common approach.
A fixed percentage increase is the other main option, with 3 per cent the most common increase; 4 per cent is considered a big increase and anything above that is recognised as very high. Most tenants would find a 4+ per cent increase unsustainable for their cost base.
It’s worth noting that different markets have different rules, but most use the CPI or 3 per cent. What this means for your return on investment is that with each annual price increase you’ll see more cash coming in each month.
Also, when you revalue the property, the higher the rent the more equity you may be able to release.
Another way to add value is to increase the security level on your property.
The longer the lease, the greater the security. This was the first value-add we personally made to our first commercial property, a supermarket.
We were able to increase the lease from 12 months to five years. This increased the valuation as soon as the lease was confirmed.
Part of making a deal great is often a value-add opportunity. One of the easiest methods of adding capital value to your commercial property is by increasing the rent, as values of commercial properties are largely driven by rental returns or the potential for capital growth.
To determine if there is an opportunity to add capital value through rental increases, you need to understand what the going square metre rate is for similar properties in the area.
If the tenant is paying $180/sqm and every other similar property in the area is renting for at least $210/sqm, there is a potential to raise the rent by $30/sqm.
This would represent a 16.67 per cent increase in the rental value. If you purchased it at the old rental income, then your value of the asset could also increase by 16.67 per cent.
The first step is to negotiate the rental rate when you can legally do so. For example, if the lease has three years left to run, there isn’t much you can do.
However, if you are within 12 months of lease expiration, there may be an opportunity to negotiate with the tenant early on, especially if they love the property and want to stay.
Showing the tenant a spreadsheet with all the other square metre rates in the area can be a good way of enlightening them and helping to justify a rental increase.
This is a great strategy to use when the tenant is paying below-market rates. It also takes some of the emotion out of the negotiations.
You can easily research comparable properties for lease online (using sites such as CoreLogic) to see how the property you’re interested in stacks up.
Buying under market value
We have found time and time again that it is possible to purchase properties below their true market value.
This can be done by purchasing an asset off-market without the normal competition from other buyers in the market.
Or it can be done by purchasing an asset that has a little short term risk on it that devalues the asset.
This could include a very short lease or some urgently needed maintenance. Both these cases would turn off certain buyers that can allow you to purchase a better deal.
Once you fix the maintenance issues or address the short lease, your value of the asset will rise to what the market value should reflect.