Are you ready to jump into commercial property? I wasn’t for a long time, but given I own a business and rent premises it makes sense.
A few years back I enthusiastically jumped into a residential development. It didn’t work out too well, mostly because we honored sale and purchase agreements beyond their sunset date with big cost blowouts and a builder that went bankrupt.
So, it was prudent to take a few years off, otherwise risk divorce. But lingering all this time was the thought of building something unique for Squirrel. I’ve been on the lookout for the right building for two years, and now I might have found it.
As I’ve been plowing through the due diligence and writing up a feasibility report it has got me thinking. Why didn’t I do this years ago?!
If you own a business, then you can successfully use commercial property as another way to build wealth. As my feasibility is screaming at me, it can be way better than residential property if you do it right.
If you are new to commercial property, there are a few key principles to know upfront.
The value of a commercial building is essentially calculated off its ‘cap rate’ or net rent yield. At the moment a high quality building will sell with a cap rate below five percent. So to value a building, you just need to understand its lettable floor area, what rent you can get per square meter, and a cap rate for the location and type of tenant.
An A-Grade office building in central Auckland can rent for $500 per square meter and higher with a big fit out contribution. Retail space is $800 - $900 per square meter but can go a lot higher in the right location.
When looking at a building, a change in the rent from $330 per square meter to $450 per square meter will have a massive impact on the value of the building. A $5 million building with a 6 percent cap rate would increase from $5 million to $6.8 million. If the fit out to get the rent up costs $800,000 then you make a $1 million capital gain and you still have an investment earning a net six percent.
Businesses will pay more rent for a fit out (think of it like rent to buy). So typically, the value of a building will go up more than the fit out cost.
If you build for your own business (like I will), then you have an anchor tenant before you build and that will help with financing and also the valuation. It makes sense to fund the fit out and pay a higher rent as this will improve the value of the building.
If you enter into a long-term lease and are a high quality tenant, that is also likely to reduce the cap rate. The more you can lower the cap rate, the higher the valuation. A $5 million building going from a cap rate of six percent to five percent will increase from $5 million to $6 million. If we go back to the previous example and also allow for higher rent, then the value ends up at $8.2 million. That’s now a profit of $2.4 million. Yes, these numbers are on the high side and I’m making lots of assumptions, but it gives you the picture.
I like the idea of developing and also getting the developer margin. Why give that to someone else by agreeing to go into their building?
If you’ve got the hustle factor then it’s simply finding a building that is under-rented, doing a fit out and then increasing the rent’s potential with some sort of incentive upfront. The higher rent and low cap rate translate to increase in value.