Successful investment in commercial property is all about art and timing. The art, which might be described as judicious choice, is the skill needed to discern whether the particular property is likely to continually head in the same direction as the market.
Market direction (up and/or down, in and/or out) takes its cue from the economic forces of supply and demand, themselves driven by logic and steered by intuition according to the mood of the moment. The commercial property market, however, is not one vast arena where everything that is happening affects every property, but a collection of different sectors and segments each having their own individual characteristics. Notwithstanding deep ecology and interconnectedness, whether whatever is happening in the wider world would necessary rub off on each narrow world very much depends upon the nature of the event and its impact upon the behaviour of participants in each sector and segment.
When investment prices are high and yields low as they are in many places, the question is whether lower prices and higher yields that may be found elsewhere are better value through actual oversight or only in comparison. It is tempting to expect lesser locations to follow and one day catch-up, but primary locations are better because they have what it takes to power ahead whereas everywhere else does not. The art is in deciding whether a proposition has what it takes and/or is up-and-coming, or simply static or likely in decline. The skill is in deciding how much to pay for the proposition.
The market has been polarising for years. The gap between sought-after places and everywhere else is now too wide to bridge: the focus on a few at the expense of the rest. There may not be anything obviously wrong with the rest, but the property market is not fair. The inequality cannot be ironed out by overpaying for second-rate propositions while expecting rental growth. All that happens when in search of better value and yield buyers go further afield is that they end up kidding themselves.
Successful investment in commercial property is a combination of capital and rental growth. Capital growth is a product of investment sentiment; timing the momentum is a critical factor. Rental growth is a product of the terms and conditions of the tenancy; careful drafting of a lease, especially the rent review clause, is essential. The normal type of review clause to open market rent can come adrift if there is no evidence to support an increase and no desire to incur the cost and risk of dispute referral determination.
The challenge for any buyer when prices are already high is whether the value of the proposition would go that much higher to at least be sure of getting your money back should you ever want to sell. Property is a tradable commodity, but the expectation mechanism is geared to upward-only. Put options, making a profit out of falling prices, are too sophisticated for most people; deliberate negative thinking goes against the grain. For evidence of bias, you only have to listen to the outcry whenever shares prices tumble on the stock market.
For some reason, possibly reputation as a long-term hedge against inflation, property is regarded as a one-way bet. It is not. Timing and judicious choice is everything. Buying for income and wanting rental growth without the help of the rent review clause or redevelopment potential is high risk. Taking comfort in momentum as anything more than another swathe of investors jumping on a bandwagon to fall off the next cliff. When inexperience baulks at primary locations and starts buying further afield, prices get inflated to unsustainable levels.
It might seem contradictory to suggest most commercial property has gone ex-growth when investment sentiment is rising, but the challenge for anyone seeking rental growth is avoiding the lack of sync between supply and demand. Too many places, an oversupply of the wrong sort of property, a shortage of reliable tenants, poorly thought-through rent review clauses, and too many inexperienced investors only listening to what they want to hear.
Property may have been cyclical once, but times have changed. Property pricing ought not be dependent upon the availability of credit but it is. Banks loosening lending criteria invariably stimulates demand by enabling more investors to take part. The number of properties for sale by auction is a reflection of the experienced pruning portfolios of ex-growth while the going is good and before the signs become evident.
In some cases, long-term buy and hold pays dividends but each proposition must always be considered on its merits. To assume otherwise is to risk losing out. When the best time for the investor to sell is out of sync with the market, the likelihood of getting the best price is reduced.
The best time to buy is not when the world and his wife is. The best time to buy is when there’s no money about. That higher prices tempt out better propositions is only relevant if you are more interested in quality than growth, if you can afford to sacrifice margin by taking on more risk.
Unlike residential property where vacant possession value is normally higher than when the property is let, commercial property prices are generally higher when premises are let. A paradox of commercial property thinking is that lower yields are seen as commensurate for expectation of rental growth, while higher yields suggest little or no growth. The difference is not only location oriented, but also tenant covenant. In my opinion, most provincial cities and towns have gone ex-growth, apart from core positions. The digital revolution means there are too many opportunities for tenants to want to be limited to how business was done previously.
Buy carefully, otherwise when leases come up for renewal, expect to accommodate lower rents and break clauses.
The Rent Review Specialist