January 20, 2013 Neil warshafsky

Commercial Investment Primer

Commercial Investment Primer

With real estate markets in major centers on the rise, commercial properties are quickly becoming hot commodities. In Part 1 of this series, Mark David reports on why the time to buy commercial properties is now

When a prospective real estate investor looks for properties to purchase, there are a number of options available to them. The majority of first-time investors will choose to go the residential route, and will begin to build up a portfolio of residential properties over time. Some investors will tend to stick to the residential market, as it others good chances for a decent ROI and cash flow. Plus, hot residential markets will allow for them to purchase more properties and earn even more positive capital. However, as good as that may seem, these investors often overlook the fact that great opportunities also lie in commercial properties.

The  Ontario commercial real estate market has enjoyed a protracted period of positive sustained growth,” explains Neil Warshafsky, Broker of Record with RCA Toronto, Inc. “ is has been fueled primarily through a combination of low interest rates, higher rents greater occupancies low unemployment and a host of other positive factors.

There are a number of key factors, Warshafsky adds, that influence the demand for commercial properties. “Demand has spurred as a result of many influences such as higher immigration, the consolidation of real estate ownership into fewer hands through syndication, securitization and other forms of corporate ownership, and concerns over alternative investments such as bonds and equities,” says Warshafsky. “Accordingly, with fewer properties trading coupled with greater demand, property values should continue to escalate. We are still on the up- slope of the current commercial real estate cycle,” Warshafsky continues. “A generous supply of fresh capital into the market mixed with a growing economy has served to foster an ideal time for investors to step into the commercial real estate market.”

Variety is the spice of commercial properties

Just as is the case with residential investing, there are various types of different commercial properties available to buyers who are eager to make the jump to commercial real estate. there is something for everyone in the world of commercial investing, and each type of property has its own merits.

There are many types of commercial properties available to invest in. they include office, industrial, retail and multi-family buildings as the industry cornerstones,” Warshafsky says. “Also included would be hotels, nursing/ retirement homes, and other special purpose properties.”

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Regarding the types of buyers these kinds of properties would attract, it all really depends on the investors and what they are looking for. Indeed, the investors themselves are often just as varied as the types of properties available on the market. “Investor profiles would include a diverse range of individual investors, insurance and other investment companies, trusts and other institutional ownership structures,” says Warshafsky. the type of real estate investment and investor may be determined by the equity requirement, location, risk tolerance and a myriad of other factors.”

The majority of buyers like to start small when purchasing commercial properties. A “first-time commercial buyer might choose to purchase one or more smaller properties in the beginning, such as storefronts, for example. As they continue their commercial investment journey and gain more valuable experience, they might cast their nets out further and move up to offices, mid-sized industrial buildings, and other such properties.

Seasoned commercial investors might go after significantly larger purchases, which include factories, strip malls, larger shopping malls, high-rise apartment complexes, or entire office towers. e more experience the investor has with commercial investing, the more likely he or she would be to chase after the big game on the market.

The Financial Details

Commercial and residential real estate may differ from one another in many ways, but there is one unifying thread between the two – the fact that there may be risks involved when making purchases. One major issue that prospective buyers might encounter is cap rates, which are a measure of risk.

Commercial investing requires buyers to be more knowledgeable about aspects Of the purchase and ownership processes

“Capitalization rates differ depending on the type of property, the age, location, “financial covenants, size, environmental and other concerns,” Warshafsky clarifies. “Typically, the lower the cap rate, the safer the property is as an investment. Naturally, if a property is 100% leased to a national bank on a net basis, the cap rate or yield would be much lower than if it is leased to an independent ‘Mom and Pop-type’ independent restaurant.”

By examining cap rates on different types of commercial properties and the risks and rewards involved, investors can determine which types of properties are right for them. Says Warshafsky, “there is a direct correlation between the risk and reward when it comes to commercial real estate investments. As an example, cap rates for multi-family [buildings] or apartments are generally lower than those found for industrial properties.”

One important thing that “first-time investors should know before entering the commercial scene is that these types of properties tend to carry higher price tags. According to Warshafsky, “the main difference lies in the complexity, understanding and management skills required between the two. Commercial properties typically cost more on average than residential properties, so the barrier to entry is “financially greater.”

Warshafsky adds that commercial investing requires buyers to be more knowledgeable about various aspects of the purchase and ownership processes, in addition to being mindful of the “financial characteristics. “It [commercial investing] requires a better, more comprehensive understanding of leases, physical repair matters, zoning, legislative concerns, taxation issues, “financing and in general, a greater knowledge of the issues which affect real estate,” he says. “Residential ownership is a much simpler form of ownership. It is much more accessible due to the ease of buying a house or condominium.”

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Smaller Investor and Commercial Real Estate

Accessibility is another important part of the decision to buy commercial properties. Both veteran and smaller-time investors will “find that the commercial real estate market is readily accessible to them, something that may influence them to start diversifying their portfolios. Also important are the various means by which smaller investors can get into the market.

CREW14_74-79-3“Smaller investors may invest in and have access to commercial properties either directly using their own capital (such acquisitions will have disproportionately

large expenses upfront), or indirectly through REITs, buying stock in public real estate companies, through real estate syndication’s and other forms of group ownership,” Warshafsky says of smaller investors’ access to the world of commercial real estate.

However, as Warshafsky indicates, there are some “financial barriers that may make commercial investing a challenge for smaller investors. Caution should be exercised by smaller investors when dealing with these factors.

“There are significant “financial barriers to entry that will increase the cost of admission,” Warshafsky says. “Legal fees, environmental reports, physical assessments,

Appraisal costs, accounting fees, mortgage fees, management costs and other associated due diligence expenses will prevent the buyer from receiving benefits from any economies of scale.”

The fact that the majority of these costs are not scalable could potentially drive up the costs of acquiring a commercial property, which, in turn, could have an effect on profits in the future.

“Many of these costs are not scalable and as such, may disproportionately increase the acquisition costs for a commercial property,” says Warshafsky. “These expenses will affect the acquisition cost base and likely carry forward a burden which may unduly affect the returns and ultimate profit on sale.”

Although smaller investors with the capital for it are free to invest in commercial real estate, many of them expect it to be relatively simple, like buying residential properties. But in reality, it’s anything but. Certain rules and regulations for commercial properties differ greatly from residential, as do the kinds of occupants and various legal aspects.

TYPES OF COMMERCIAL PROPERTIES

There are various types of commercial properties available to investors.
They include:

  • Office space
  • Office complexes
  • Strip malls
  • Shopping malls
  • Factories
  • Warehouses
  • Storefronts
  • Hotels
  • Motels
  • Restaurants
  • Multi-family housing complexes
  • Medical centres
  • Hospitals
  • Nursing homes
  • Garages
  • Distribution centres
  • Sports facilities

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“Residential properties are somewhat easier to manage and understand. The tenants are residential occupants, so the laws, management issues and other related matters are fairly uniform,” Warshafsky explains. “Commercial leases, tenant issues are more complicated and challenging. Issues such as complicated amortizations, chargeback’s, exclusivity concerns and many other legal and managements concerns are the norm in commercial ownership.”

Proper knowledge of the commercial market is another requirement, as those who lack it are potentially liable to make costly mistakes. It is better for investors to arm themselves with as much knowledge as possible before closing a deal, for if something goes wrong, they may find themselves in a heap of trouble.

“A commercial investor must have a much broader knowledge of real estate issues,” Warshafsky advises. “Commercial properties are not as liquid as residential properties, so in the event of a disposition, the process may not be as smooth.”

Hot residential markets vs. commercial markets

Both residential and commercial markets in most major metropolitan areas can be incredibly volatile. Either market could alternate between periods of heavy activity and drought periods where fewer properties are sold. !e choice to invest in either type of property is always available, but those who invest in commercial real estate often choose to stick with their guns for as long as possible.

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“If the residential market gets hotter, it is likely that new, less sophisticated investors will enter that market,” says Warshafsky. “Certainly, investors will have a choice and some will remain and continue to  invest in the residential marketplace. Commercial investors remain dedicated to their choice of investments. !is [type of] investor is somewhat more sophisticated and knowledgeable. Many have experience through several real estate cycles and do not normally flip-flop between [the two types of properties].”

RESIDENTIAL VS.COMMERCIAL PROPERTIES

Both residential and commercial real estate offer worthwhile investment opportunities

for potential buyers, but the two have many differences, especially in terms of pros and cons. Here, Neil Warshafsky breaks down the pros and cons of each.

ACCESSIBILITY TO INVESTORS

Residential properties are much more accessible to an investor, and are much easier

to locate and acquire. They normally require less capital, and usually have less risk associated with them. Financing for residential properties is more readily available. Selling and disposing of residential properties is also much easier. There are many reasons why a typical investor may look at residential investments as an option. There may be renovation costs involved, but typically these costs can be quantified and controlled.

EXPERIENCE VERSUS CAPITAL

Commercial properties typically have more “moving parts,” and require more expertise. Generally, they require more capital and more upfront expenses, and may not be as liquid on exit. When being acquired, there is a much more comprehensive and complicated due diligence process which would likely include the involvement of a lawyer, accountant, environmental expert, physical inspectors, mortgage brokers and possibly other consultants. In addition, there may be costs upfront to renovate, for leasehold improvements, incentives to tenants, commissions, etc. Commercial properties are not as easily financed and the loan-to-value ratios are normally lower than that for residential properties and as such are much more capital intensive. Commercial properties are not for the faint of heart and require a lot more attention.

GENERATION OF GOOD RETURNS

Both can generate very attractive returns, but investors should be knowledgeable about the nature of each of the investments. The returns for either investment may be good; and commercial properties have the potential to generate high returns as they are influenced by many factors. These may include: increased rents, hence cash flow and value; change of use through zoning; and the possibility of increased density and many other potential factors which may produce greater yields.

Observing market trends for commercial properties

As there are various types of commercial properties available in most major markets, the outlook for each one is different. According to a recently-published report from PwC, rents and values for office spaces are on the rise. !is has allowed for the construction of many new office complexes across the country.

Demand for office space is also steadily increasing due to falling unemployment rates in some markets, and commercial developers will be looking to capitalize on this as much as possible. Environmentally-friendly developments will likely be a big hit with investors, as they seek to house more employees within smaller capacities.

For retail spaces, PwC indicates that the markets are tight and will continue to tighten, thanks to northward expansion by many major U.S. retail chains. A perfect example of this is American retail powerhouse Target’s displacement of nearly all of Canada’s Zellers department stores. !is, says the report, could signal “a dynamic moving around of tenants,” and could possibly “sound the death knell for some weaker domestic brands in the most Darwinian of property sectors.”

Property owners, however, are interested in this activity, as some U.S. brands have experienced difficulties in entering the Canadian market. Key factors like zoning issues and vigilant lenders have ensured that new developments will be kept in check for the foreseeable future.

Industrial properties are also part of the commercial sector, but unlike retail and office spaces, they have been on the decline. the PwC report specifically points to warehouses as having very limited vacancies across the country. Potential investors should take note of the fact that growth in the industrial sector has been relatively slow, and this can be attributed to high currency exchange rates and the state of the economy in the U.S.,

Demand for office space is steadily increasing due to falling unemployment rates in some markets

Which in turn, has had a significant impact on both imports and exports? Supply is not  the issue here, the report explains, as weaker leasing markets have forced developers to shift their focus away from new industrial starts, despite average rents that are lower than property replacement costs.

Looking ahead

Increases in population often have a profound effect on major markets. For residential properties, spikes in population result in the construction of numerous new starts in order to keep apace with the growing demand. !is is just as applicable to commercial properties as it is to residential properties. As Warshafsky explains, if interest rates remain low and demand increases, the outlook for commercial investing will be very favorable for potential buyers.

“In the NationalPost, it was stated that the population within the GTA is expected to increase by 2.6 million people by the year 2031,” Warshafsky says. “Assuming interest rates remain low over the next few years, and demand remains high, along with the fact that commercial real estate is falling into fewer hands, the picture for the commercial real estate market remains very positive.

“there are fewer transactions, as investors are concerned over where they can re-invest, and many of the institutions and REITs do not re-sell their assets on a regular basis,” he continues. “It appears at least for the next several years that the demand will continue to outstrip the supply.”

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