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Should NRIs invest directly in commercial properties?

Commercial estate tends to be more lucrative than residential, something that is not lost on most NRIs. But is it truly a good investment?

Commercial properties refer to offices, retail shops, warehouses and industrial buildings that conduct business in order to generate profit.  They are different from residential properties in which people dwell and some NRIs are eyeing commercial properties for investment purposes. 

NRIs need to consider the following factors before investing in it:

Poor diversification

With REITs (Real Estate Investment Trust) yet to catch steam in India, most NRIs are investing directly in commercial properties that require a big-ticket investment. This is a big drawback as they will not be able to diversify investments (like REITs) across cities and projects and reduce risk.

Commercial property also costs more (on a per-square-foot basis) as against that of a residential property. For instance, a residential flat might sell for Rs 8,000 per square foot (PSF) while a shop in the same premises could cost Rs 12,000 or more psf. 

Uncertain yields

High rental yield is one of the biggest triggers for investing in commercial property. Rental yield is calculated as annual rent as a percentage of property market value. Currently, one gets a rental yield ranging anywhere from 6-12% annually as against 2-4% for residential properties in India. 

However, a lot depends on the quality of the property as well as the tenant. For instance, top properties (‘A’ grade) with state-of-the-art infrastructure and amenities get better yields than the rest (‘B’ of ‘B+’ grade properties). Similarly, properties with bluechip companies and multinationals as tenants are likely to command a premium over the others.

In a commercial deal, tenants are typically handed over properties as a ‘bare shell’. It means that tenants have to carry-out fit-outs for flooring, air-conditioning, wiring and others from their own pocket. 

Fine print 

Also, don’t get duped by the higher rentals marketed by builders. In a commercial deal, tenants are typically handed over properties as a ‘bare shell’. It means that tenants have to carry-out fit-outs for flooring, air-conditioning, wiring and others from their own pocket. 

Sometimes builders do it for their tenants at a cost which also jacks-up the rental cost – making the yields look attractive in the process. However, rent for such fit-outs is not permanent and applicable only for a limited period of the initial three to five years. 

Market factors

There are multiple micro-markets within a city. If more office space, for instance, is coming up in the vicinity of those micro-market, then there could be pressure on existing rents. More supply can make your tenants renegotiate rates at lower rates when it comes up for renewal or lower occupancy rates. 

Also, a lot depends on the Master plan for the area under consideration and how it is expected to develop over a period of time. Nevertheless, a lot is left to market forces (demand-supply situation). 

Exit price 

Supposing there are two commercial properties adjacent to each other with its tenants paying different rents. 

For a moment, imagine a Property A which sells for Rs 105 and has its tenants paying annually Rs 11(10.5%)

Property B which sells for Rs 95 and has an annual rent of Rs 9 (9.5%)

Which one would you buy? The figures in the bracket indicate its rental yields.

If one decides on the basis of rental yield, property ‘A’ looks attractive. However, should we also not compare it with the going market rate as well? After all, if the market rate is lower, there are higher chances of its rent getting renegotiated (or increasing vacancy). Property ‘B’ in that sense looks a safer bet, as its tenants are more likely to continue and are also available at a relatively lower value. 

So, what you earn from the sale of commercial properties is not just a function of going market rate, but also at what rate you have negotiated the leases with your existing tenants. 

Long leases

Commercial leases in India are, typically, of a long-term nature – say 3+3+3 years or for 5+5+5 years. Every three years, there might be a clause for 10-15% escalation in rentals typically to catch up with inflation. In the past, there have been many cases where such long clauses have worked against the interest of investors when the market rates have risen faster than the negotiated rates. 

Moreover, in India, since tenants invest a lot in interior fit-outs, leases are typically longer. Also, the lease break clauses are one-sided whereby only the tenant has the right to terminate the contract by giving a notice of three to six months. 

While long leases give stability of income, it can also prove detrimental especially if market rates are galloping.

Takeaway

NRIs should not get carried away by high rental yields promised for commercial properties and understand the pros and cons. They are better off investing in equity funds that aim to provide 11%-12% annualized returns over the long-term for their investors. 

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