Commercial property is used for business activities, or to generate a profit through the collection of rental income or capital gain.
It can be in many forms including office buildings, hotels & motels, medical facilities, retail shops and shopping centres, farm land, warehouses and storage facilities.
In this short blog we compare this class to Residential property, and talk about some other terminology such as the “ICR”, “WALE” and “Cap Rate”.
Comparison with Residential Property
i) Positives
Longer Lease Profile
The average lease for a commercial property is much greater than residential, measured in years rather than months. As a result, commercial tenants tend to offer greater stability and certainty of income.
Tenant support for Outgoings
Commercial tenants typically cover outgoings such as council and water rates, insurance, body corporate fees etc. Some laws will prohibit passing on “expenses that do not benefit the premises” but they can be passed on more readily than residential.
Value stability relative to other Asset classes
Relatively speaking, there has been less price fluctuations in commercial property values.
Tenant supported Asset improvements
Tenants are more likely to make improvements to the structure and layout of a commercial property, which can be beneficial to its value in the longer term.
ii) Risks
Commercial property is not without risk. We have seen it go wrong for our customers a number of times. This is generally the result of not understanding the risks, or having the necessary financial support in place when things go wrong.
So always consider:
Vacancy Periods
Commercial properties run the risk of being untenanted for extended periods of time, the lead times can be extensive in finding a suitable tenant. This means covering expenses during this period.
For people with multiple properties, understanding the profile of your leases becomes. You should understand your WALE. Investors are generally prepared to pay a premium for assets with longer WALE’s.
Exposure to the Macro Economy
A very obvious point right now, especially during the Convid crises. The resultant economic downturn, weak business conditions or high unemployment may mean that there is less demand for commercial property.
Maintenance Costs
Yes, whilst your tenant may make some improvements to the property, the cost of upgrades when things breakdown, especially for a larger retail or office site, can be really expensive compared to other asset classes.
Understanding the “Cap Rate”
The capitalisation rate, more commonly called the “cap rate”, is defined as the ratio of net operating income (“NOI”) to the property’s value. Whilst it does not represent a detailed analysis of the property investment risks, the cap rate is a useful industry ratio and it can be helpful in comparing different investment options.
Let’s take an example:
Listed Property Price $2,000,000
Net Operating Income $120,000
Cap Rate = $120,000 / $2,000,0000 = 6.0%
In the above example, this investment of $2,000,000 would produce an annual return on investment of 6%. Another way to analyse the cap rate is to show it as a multiple. In this example, 100% / 6% means that we are paying a multiple of 16.7 times the NOI. This is a language more common in comparing valuation methodology for other asset classes.
Looking at cap rate trends can give you insights into the direction of valuations. For example, we have seen cap rates roughly halve in Australia since the GFC. This is not surprising, as yield across all asset classes have fallen, and a guide to commercial property is its strong correlation to bond yields.
That said – it is still hard to see some retail property in Melbourne for example, sell on a yield as low as 3%, with all the risks.
Finance & the “ICR”
With interest rates at historical lows, borrowing for commercial property should be easier right? Well, in short, no. Firstly let’s look at the profile of commercial property lending in comparison to residential property:
– Higher interest rates
– Lower loan to value ratios (60% – 75%)
– Longer lead times on valuations & assessment
Commercial borrowers do also tend to have more complex structures, making serviceability more difficult to assess.
The ICR Model
As a general rule, servicing gets isolated to debt applied for and rental income from the commercial property offered. This is where we use the Interest Cover Ratio or ICR.
This is calculated as the NOI / Interest Expense. Typically, the lender will “stress” or buffer the interest rate which results in a higher than actual rate being applied.
As an example using a serviceability assessed via an ICR:
Net Operating Income: $120,000
Total Borrowings: $1,400,000
Interest Rate (Stressed): 7.0%
Interest Expense: $98,000
ICR Result: 1.22 times
In this example, the lender has an ICR “hurdle” of 1.3 times so a loan at the desired level would not be approved. This is despite an ICR of over 1.30 using the actual or “unstressed” interest rate.
This will often mean that the financier will need to consider the applicant’s other income to support the lending.
Of course, ICR is not the only assessment that the financier will use, as it does not take into account principal repayments, or indeed the lease term or WALE. However, the ICR is a big reason why so many people seeking property investment finance fall short.