Sorabh Jain explains the finer points of investing in commercial real estate.

Real estate has been attracting the attention of investors as an alternative to stock and bonds. This interest is being driven by the stock market's negative returns in recent years and expected returns for fixed income in the near future. Investment in income yielding commercial real estate provides various benefits. Such as:

• regular income (as governed by contractual obligations);

• capital appreciation (hedge against inflation);

• low correlation with other class of assets (helps diversification and hence reducing overall risk in portfolio)

• rent (income) generally tends to rise with inflation.

Although real estate is considered an asset class, it consists of different sectors. There are mainly two broad divisions:

• Residential Sector

• Commercial Sector

Within commercial property, there are types you can choose from:

• Office space

• Industrial

• Retail - malls, restaurants, shops, shopping centres, etc.

• Warehousing and distribution

• Hospitality - Hotels & Resorts

• Basic services - schools, colleges, hospitals, etc.
   

The office, industrial, retail and residential sectors do not react in the same way, with the same amplitude or at the same time in a given market during a recovery or recession. Analysis and selection of individual sectors (and sub-sector) are important. The cycles can also differ with geography.

The type of property and sector one decides to invest would depend on:

• Availability of funds;

• Expected Returns;

• Risk profile;

• Time Horizon;

• Investment objective - income and/or appreciation;

In today's economic environment, and given the inefficiencies in the real estate market, an investor can identify opportunities at the individual property risk level (i.e. physical characteristics, location, leases in place), and thereby outperform the market by doing superior research. Following factors need to be considered:

1) Leasing out the property - lease terms that should be planned:

• Tenure or length of lease

• Type of arrangement and agreement - pure rental, rental plus commission, conducting basis, franchising, deposit, etc.

• Lock In Period

• Escalations in lease rent

• Payment of running expenses - outgoing, municipal taxes, maintenance, electricity, repairs, renovations, etc.

• Termination clause

• Refund of security deposit

• Safety of premises/property

• Cap-ex leakage (furnishing, rent free period, improvements, special needs of tenants)

2) Locating a suitable lessee

• Suitability of property to a particular client

• Built to suit

• Business and financial position of lessee

• Reference check

• Rent commensurate with the nature of business

3) Negotiating the terms

• Current market scenario - knowing the background of a market

• Vacancy costs

• Getting the right client

4) Closing the deal

• Win-win situation

• Financial structuring (advance rent, high deposit, annual escalations, etc)

• Legal compliance

While it is difficult to predict precise market timing, it is not difficult to spot a trend and profit from it by relying on fundamental economics and market analysis, coupled with rigorous property level analysis. To choose a commercial real estate investment, it is necessary to analyze both the market and the specific property. Focussing in on property level factors in today's shifting economic and real estate environment is the key to successful investing on a risk-adjusted basis.

(Sorabh Jain is a Chartered Accountant. He holds a Masters degree from London Business School. He is a Director of Principal Real Estate Advisors Pvt Limited. The views expressed above are personal).

This article appeared in Times Personal on August 05,2003

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