Checklist buyer: what you should know before purchasing commercial real estate
Purchasers of property abroad are increasingly seen not only as shelter but also as an object for profitable investment, especially in times of crisis. In the study “Cranio” for 2014 investment attractiveness is for the Russians the second most important factor when buying property abroad.
In comparison with the acquisition of holiday homes investing in commercial properties require a more serious approach and thorough analysis. To save time and avoid costly mistakes, before buying you should know the basic parameters of the investment project:
- location;
- budget;
- expenses;
- features of the lease agreement;
- yield;
- risks;
- financing;
- management options;
- an exit strategy from the project.
Location
In what locations is largely a function of its profitability, risks and liquidity. For example, trust investments in the large cities of Austria, great Britain, Germany, USA and France. Studying the information about the object’s location, you should pay attention not only to the country and the city, but the area in which the property is located, namely:
- on infrastructure: for example, investing in apartment buildings it is important the presence of nearby Parking, and social facilities and shops;
- the advantages and prospects of the area: this depends on whether the increase in the future value of the object and the income from the rent;
- transport services by the district: where is the nearest public transport stop, whether there is free access to the motorways, what is the distance to major transport nodes.
Budget
As a rule, buyers are investing in commercial property requires a minimum of 2.5 million Euro, as with a smaller amount hard to find quality and low-risk object. Of the budget depends largely on the choice of the type of real estate.
Types of commercial real estate and their parameters
Tranio data (average recommended values)*
| Types objects |
The yield, % p |
Time contract rent |
Advantages | Disadvantages |
|---|---|---|---|---|
| From 300 thousand euros | ||||
| Apartment (short term rental) | 5-7 | From 1 day | High liquidity; compared to the long-term lease — higher yield and no problems with the eviction of tenants; the potential for rental growth | Risks and management of downtime; compared to a long-term lease — more rapid wear |
| Apartment (long term rent) | 2-3 | Than 1 year | High liquidity; high demand from tenants, stable even during the crisis | Risks and management of downtime; problems with the eviction of tenants |
| Student housing | 4-6 | From 6 months | High demand from tenants | Compared to apartments — lower liquidity, it is difficult to repurpose |
| From 2.5 million euros | ||||
| Apartment houses | 3-5 | Than 1 year | High liquidity and growth potential of the capitalization | Low yield, lots of tenants, problems, eviction, need a management company |
| Street shops | 3-4 | 3-10 years | High liquidity and growth potential of the capitalization | Low yield |
| Supermarkets | 5-6,5 | 12-15 years | High yield, long-lasting contracts | The closer the expiry date of the contract, the lower the liquidity |
| From 10 million euros | ||||
| Nursing home | 5-6,5 | 20-25 years | The growth in the number of pensioners, long-lasting contracts | It is difficult to repurpose |
| Shopping malls | 4-6 | 5-15 years | High yield | Risks management for a large number of tenants |
| Hotels | 4-6 | 10-20 years | High yield | It is difficult to repurpose |
* Average values for objects:
- in affluent areas of major European cities;
- new objects, or after major repairs;
- rental contracts at the beginning of the period of validity.
The cost of purchase and maintenance
When planning the budget it is worth considering that the cost of processing transactions range from 5% to 20% of project cost depending on the type of property, price, and type of transaction. Such expenses include notary services and the cost of state registration, purchase tax, Commission and broker expenses on procedure of verification of legal purity of the transaction — Due Diligence.
In addition, after the purchase of the owner waiting for the costs: the costs for the services of a management company, utilities and repairs, insurance and taxes (property tax and corporate tax). Investors are advised to pay attention to the presence of tax exemptions and deductions and the conditions for their receipt. They can significantly reduce costs and increase profits.
What costs are borne by the owner and which the tenant depends on the type of rental contract.
Tenants and lease agreement
When studying the conditions of the lease should determine, if the object is commissioned, who is an anchor operator and what is the reliability of individuals or companies renting space. You should pay attention to the percentage of leased space — ideally, the average annual occupancy rate shall not be less than 90 %.
Also important is the type of rent (it depends on the amount of maintenance costs, and, hence, profit margins).
Types of lease
| Type of lease | Features |
|---|---|
| Gross rent lease | The property owner performs all calculations for utilities, expenses on repair and operation of the building, pays insurance, and (sometimes) taxes |
| N lease (Single net lease) |
The lessee pays tax only on real estate, all other costs borne by the owner |
| NN lease (Double net lease) |
Tenant pays taxes and insurance |
| NNN lease (Triple net lease) |
The owner charges the tenant a fee, “triple”, that is without deduction of tax, insurance and maintenance costs (these costs under the agreement are borne by the tenant) |
| Absolute NNN lease | All costs are borne by the tenant, even if the building is damaged during a natural disaster and need partial redevelopment |
For investors the best last two types of contracts: in their opinion, the costs of maintaining the property from the owner is minimal.
You should also pre-determine the duration of the lease. It largely depends on the willingness of investors to take risks: for example, if he’s not ready to lose tenants, it is likely to invest into the property with long term lease contracts. Conversely, when the risk for the investor is acceptable, he will consider the property suitable to an end or short-term rental contract.
Yield
Under the yield can be considered the absolute annual income, cash flow, operating income, capitalization rate, growth, cost, cash-on-cash ROI and IRR. It is important to understand what type of yield is talking the seller. For example, as illustrated by the example below, the IRR could reach 9 %, while the capitalization rate of 5.5 %.
Sample data
| The value of the object | 10 million euros |
|---|---|
| The cost of buying | 1 million euros |
| Investment | 5 million euros |
| LTV | 60 % |
| Interest on the loan | 2.4 percent |
| Rental income | 650 thousand euros per year |
| Operating costs | 100 thousand euros per year |
| The rising cost | 2% per year |
Types of yield
| Type of return | The definition and method of calculation | Example |
|---|---|---|
| Absolute annual return | That gives a rental property in the year before deduction of operating expenses, payments on mortgages and taxes | In the example the object value of 10 million euros generates an absolute annual income of $ 650 thousand euros |
| Net operating profit | The absolute annual income, minus operating costs | If the estate brings 650 thousand euros per year and the operating costs amount to 100 thousand euros per year, the net operating profit is equal to 550 thousand Euro |
| Net cash flow | The annual profit taking into account the operating expenses and mortgage payment, before taxes | In the example net cash flow is equal to 300 thousand Euro per year (650 million (rental income) – 100 million (operating costs) – 250 thousand (mortgage payments)) |
| The capitalization rate (cap rate) |
The ratio of net operating income to the value of the object | If the net operating profit is 550 thousand euros per year, and property worth 10 million euros, the capitalization rate — 5,5 % annual |
| The rising cost | Shows how many per cent a year (the forecast) will increase the price of the property | In the example, the value growth is 2 % per year |
| Cash-on-Cash ROI (Return on Investment, profit margins on invested capital) |
This figure is equal to annual net cash flow divided by invested funds | In the example, cash-on-cash ROI will be 6 % per year (300 thousand (net cash flow) / 5 million (investment)) |
| IRR (Internal Rate of Return) |
Based on the performance of all cash flows over the entire period of the project | If the object in the example above for 10 years generates a cash flow of 300 thousand euros, and then the investor sells it for 12 million Euro, IRR will be 9 % per annum |
Risks
Risk is the probability of losses as a result of any changes. The more chance that will happen some negative event, the greater the risk. If the investor wants to make big returns, it needs to be willing to accept greater risk. For example, in the key office market in Central London — the demand exceeds the supply, and this leads to decrease of profitability in the segment (at the rate of about 4 %). At the same time, the office market in less popular areas gives the investor a far greater return (for example, in Liverpool — 7 %) with slightly increased risk.
Funding
In some cases, investors take a loan to buy commercial property. This option is beneficial so that the loan is a lever for increasing profitability. Those who decided to use Bank financing, is to figure out what terms you can expect:
- what is the size of the loan compared to the value of property (Loan-To-Value Ratio, or LTV);
- what is the interest rate;
- what is the loan period;
- what is the Commission for credit granting.
When buying investment property in Germany, the borrower can expect a loan of 60% of the property value at 2% per annum. When you rent of the property yield of 6.5% return on invested capital based on the loan can reach up to 8-10 %.
Georgy Kachmazov
CEO and founder Tranio
Management
“Good management is similar to a delicious lunch in the restaurant: the food is beautiful in appearance and taste, and the waiters are caring and helpful. Most importantly — you don’t have to care,” writes Craig Coppola (Coppola Craig), broker at commercial real estate USA.
Of course, the owner can manage on their own, but it is more convenient to hire a company that specializes in real estate management as this will help save time for the owner of the object.
Exit strategy and timing of investments
There are two exit strategies from the investment of the project is the transfer by inheritance and sale.
- The transfer of property by inheritance. Over the years, the value of the property increases, and the same object can be owned by the same family for over 100 years. Therefore, the transaction should be structured so that the property could be inherited with a minimum of tax losses. For example, in France it is advantageous to purchase property civil company real estate transactions (SCI) — in this case, there are no taxes on inheritance and donation.
- Selling. The usual period of ownership of income property before resale — 10-20 years, but there are situations where the wearer needs to withdraw from an investment project early, so the object must be liquid, i.e., such that it can be sold quickly (2-4 months) without significant loss of value. This is achieved through the purchase of real estate in premium locations, variability of use object, etc.
Conclusion
Competent assessment of all items in this check-list, made before the purchase of the property will help to protect real estate investments. Thus it is necessary to choose low-risk liquid objects in stable markets and not to chase big returns.
Yulia Kozhevnikova, “Tranio”
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