The Covid-19 Coin
The commercial property experience has been the flipside to the residential post-pandemic, writes Jeff Brill.
1 January 2021
2020 could be likened to the 1940s - when people gathered around the wireless to hear about the state of the war - which battles were currently being fought by the local soldiers and how we and our allies were coping. Some 80 years later we are glued to our television sets to see and hear what the latest casualty rates are in our respective countries and how we are progressing with the creation of a metaphoric nuclear weapon to put a stop to it: the vaccine. The big question back in
April 2020 was not only how quickly the property market would fall, but how far and what would be the resultant damage? As it turns out the market went in completely the opposite direction and residential property prices broke records in a Covid-fuelled property boom. This was great for the mum and dads who had property and the speculators who were happy to hold their investments past the bright-line period, but not so much for the long-term property investors that want to live on the positive cashflow from high yields. The rental levels did not follow suit and what was already a lacklustre return just got worse.
The other side of the Covid-19 coin is the impact on commercial property. The effects of the pandemic to date shows a national unemployment increase, people starting to work from home and a corresponding office vacancy increase.
Compared to residential, the number of transactions in commercial went south and have since settled, albeit favouring certain sectors. The game has slightly changed: where before investors would look for the best yield they could get (with a corresponding good tenant covenant and lease term), now out of all the commercial sectors, the darling is still industrial but the survivability of the tenant is the primary factor.
So how does one navigate through Covid-19 and buy an investment property that will see the investor in a better position in ten years than they would if they had invested their funds in a residential property? There are certain anomalies one needs to watch out for and I have outlined two of them below:
1. Sale And Lease Backs
In a market such as this, where vacancies are relatively high, landlords will provide rental incentives to entice tenants in this Covid-19-created tenants’ market. When this happens, the rent is sometimes reduced by several rent-free months being offered which correspondingly reduces the rent per square metre for that property. This action will follow on to affect the market value for other similar properties in the area. An unwary investor may come along to purchase the property at his/her rule of thumb return they have told themselves they will buy at and then sit back with high expectations of at least a nominal increase at the next rent review. The purchaser will look at other properties currently on the market for lease and take note of the market rent thinking that he/she has purchased a property housing a tenant that is paying a similar rent, so all is good.
If the rent review is set to market rent, as opposed to being fixed to CPI or another measure, then any valuer worth their salt will take into account the pandemic-induced rental holidays, average out the rent and there is a better than even chance that the new market rent will be less than the current market rent.
Hopefully you will have a hard ratchet clause in your lease agreement and the rent will stay the same and not be reduced. The point here is to analyse an investment carefully when you see that an owner-occupier is selling their property and then leasing it back, so the previous owner is now the tenant.
There is a very good chance that the seller has put a rental in their lease that is very much the same as the rental levels you see advertised on Trade Me or realestate.co.nz, however that doesn’t mean that is the market rent. The devil is in the hidden detail. A small difference in the rent can make a big difference in the value of a commercial property.
For example, if the lease showed a rent of $60,000 a property may be worth $1,000,000 when using a cap rate of 6%. If the market rent was $55,000, then using the same cap rate, the value of the property has just dropped down to $917,000.
As a new budding commercial investor, the solution to this problem is to talk to the real estate agent and discuss quantifying the future rental review figure now as opposed to waiting until rent review time. In other words, decide on how much you think the rent should be in two years (rent review time) and write that figure into the lease. I highly recommend you engage a valuer experienced in providing rental valuations for that particular sector.
Note that a valuer who is experienced in providing rental valuations for industrial property may not be the right valuer to use for retail property
2. Office Space
Investors should always enquire about the financial health of the tenant in the commercial property they are thinking of buying, especially in this post-Covid market where companies have been financially propped up by the Government. When the tenant is a tourism operator, an English language school, a motel by the airport or a large travel agency specialising in overseas holidays and cruise ship adventures, then you would be wise in recognising why the investment seems like a great deal with a high yield.
As more companies embrace the work-from-home ethic and Unilever test out the four-day working week, it seems like we are in a transition period but to where, no one knows. The vacancy rates in office space are likely to climb in the main city centres over the next year at least and if you have an eye for transformational development then this is your market.
As the regulators start to again flex their muscles, we see the loan-to-value ratio restrictions return to 30% in view of slowing down the exploding residential property market. This will put the quantum of the residential deposit closer to the deposit required for commercial property investment and investors will start to compare the risk.
The table below has been extracted from a CBRE research report showing the average commercial yields throughout New Zealand from each sector.
Is a long-term lease of six years with a safe tenant producing a 6% return (with the tenant paying for the maintenance, rates and insurance) equivalent or better to a residential investment returning 3%? The lending rates for commercial are slightly higher but you can balance that with the fact that you have to pay your own council rates, insurance and maintenance when you own a residential investment. When the tenant has an “essential service” badge, has been around for many years and the rental reviews are fixed, then a commercial property wins hands down in the risk/ yield stakes.
Typically, these commercial yields will be higher than residential by a factor of approximately 2%. The same research report indicates that the vast majority of transactions in 2019/2020 occurred from private investors and this is expected to continue. The commercial property environment can be a place where angels fear to tread, however those that skill themselves up find it quite easy and are able to spot growth opportunities much like a residential investor spotting a do-up.