The Basics of CRE Investment
As a long-term investment option, real estate is a great choice. While residential real estate has to deal with some amount of insecurity, commercial real estate is the most stable asset class that can aid in wealth creation. The concern behind commercial real estate investing mostly lies in the fact that there are not many resources that explain this facet of investment. As a result, even seasoned investors are wary of stepping into this unfamiliar domain. However, understanding commercial real estate (CRE) and the investment process is quite easy. There are a few simple points to bear in mind and keep your mind sharp about the changes in the market. That is all it takes to enter and benefit from CRE investments.
Let us first outline what needs to be understood about CRE –
- Location
- Asset Quality
- Demand vs. Supply
- Furnishing
- Rents
- Tenant Quality
- Lease Structure
- Security Deposit
From the perspective of any kind of real estate, all these points matter, but they are even more crucial when it comes to commercial real estate. In the following few short paragraphs, you can gain a clear understanding as to why this is so. For all purposes of any commercial real estate space, we will be using the term asset or CRE from this point onward, to keep things concise.
Location just does not mean if the asset is based in any metro city or hub of activity. CRE provides returns via rent and capital appreciation. The longer your tenant stays, the more stable your return. That depends on the vacancy rate of the location. In areas where the vacancy is less than 4-5%, tenants are less likely to scout out other spaces to rent. Investing in an asset here will ensure stable rents and gradual capital appreciation as well.
Asset quality can be summarized by the number of amenities, open spaces, elevators, lobbies, the height of the ceilings, and the like. If an asset has a LEED gold or platinum certification, it will attract more tenants than another building in the same vicinity. Developers can also indicate classes such as A, B+, or B to indicate how the asset is. Faster occupation leads to faster returns on your investment.
Demand and supply play a very crucial role in deciding how your investment in CRE will fare. As a market, Mumbai might look lucrative, but the dynamics or its micro-markets decide how your investment will perform. A historically high supply compared to demand will mean low rents, i.e., low returns. Annual demand in India and major cities is published by companies like JLL, Knight Frank, Cushman, and others.
Furnishing or fit-out can be done by the developer or by the tenant. However, it is important to know that the rent including the furnishing is payable only for 5 years from the time the fit-out has been done. An ideal investor would always take decisions based on the base rent, not the fit-out rent.
Coming to rents, let us take a small example. Consider that Asset A has a tenant paying Rs 100 and is being sold at Rs 1000, Asset B has a tenant paying Rs 90 and is being sold at Rs 995, and Asset C has a tenant paying Rs 110 and is being sold at Rs 1005. The asset prices are too close. So, which one do you pick? The tenant paying Rs 110 might give the highest return. But what if the market rent is Rs 95? Asset B would then be your best bet, as this tenant has no reason to look for cheaper options.
Tenant quality is a no-brainer. Established companies, national and multinational are way better choices as tenants. They pay higher deposits, pay rents on time, and stay for longer.
Lease structures for CRE are different than residential ones. They can be structured like 4+4+4 years (12 years) with escalations in rent every 4 years. These are one-sided lease terms. The tenant can vacate anytime, but the landlord cannot ask them to do so within the lease period. Additionally, a lock-in period will also be present. The longer the lock-in, the better it is for the investor.
Security deposits for CRE mostly hang around 10 to 12 months of rent. Any less than that, and the tenant might be looking for a short-term solution or might be having cash flow issues. Tread carefully.
Finally, this need not be said, but diversification is key in any kind of investment. That holds equally good with CRE. While one asset might not generate a high enough return, another will step in to compensate for it. If you are confused about how diversification works in CRE, well, Strata is the solution. The fractional ownership model offered by Strata helps you distribute your corpus into multiple assets. To know more about how we do that, visit us at www.strataprop.com.