When things go wrong in commercial property investment they can really go badly wrong, because the consequences are often counted in millions or rands. Owen Holland, Business Partners Limited (BUSINESS/PARTNERS) national asset manager: properties, lists five common mistakes made in commercial property investments.
Before you venture into your next commercial property deal, says Holland, it pays to be aware of the following common mistakes so that you steer well clear of them.
Common mistake 1: Shoddy due diligence
Fundamental flaws in a commercial building can be completely hidden from sight, says Holland. A perfectly sound structure might be built half a metre over the boundary line – a mistake that puts you at the mercy of your neighbours and one that may cost you millions to fix.
The only way to avoid these pitfalls is to perform a due diligence investigation in which every aspect of the building is checked: not only the condition of the physical structure, but its plans and approvals, the facilities such as water and electricity, and the state of the leases if the property is being bought with existing tenants.
Holland says it is crucial to hire professionals to perform a due diligence investigation. They can cost up to R30 000 depending on the size and complexity of the property, but their costs are negligible compared to the money they can save you.
When you are keen on buying a commercial property, Holland’s advice is to sign an offer to buy the building subject to the outcome of a professional inspection, including the structure, facilities and leases. If the investigation exposes any defects, you can either walk away or renegotiate the sale with seller. Either way, the cost of hiring professionals is money well spent.
Holland says even vacant land should be subject to due diligence in the form of soil inspection. Again, this is expensive, but your building plans may be scuppered by the existence of, an unexpected geological structure, a hidden rubbish dump, or even toxic waste buried in the soil.
Common mistake 2: Not calculating upgrades and future maintenance costs
A thorough due diligence must not only look at the current health of the structure and facilities but must include a careful consideration of upgrades and maintenance that may be required in future. These can pounce on the buyer quite unexpectedly, says Holland. An anchor tenant might only agree to renew their lease if certain upgrades are made. The rise in electricity costs may force the new owner to upgrade the property to become more energy efficient in order to remain attractive to tenants. An asbestos roof may have to be replaced.
“The buyer must be aware of the fact that the seller will always know more about the property,” says Holland. It is up to the buyer to discover the hidden costs before buying. The seller won’t volunteer the patent information.
Common mistake 3: Not considering the bigger picture
Even if the property itself is in a pristine condition, the area in which it is situated may have reached its peak and is in a downward spiral. If you buy property in a devaluing node, the value of the property will decrease, says Holland. It is therefore just as important for the buyer to look into what is happening to the area as it is to investigate the condition of the building itself.
Well-known examples are the CBDs of Durban and Johannesburg which devalued dramatically as Umhlanga and Sandton became the focus of development. Holland warns that properties in the high streets of many towns and regional centres can be significantly affected by the establishment of a mall on the outskirts.
Nothing beats driving through the streets of the node in which you intend to buy. Signs of refurbishment, development and rejuvenation are good. A lack of upgrade activity could signal the fact that the node may have reached its sell-by date.
Holland also recommends speaking to municipal town planners and local developers to find out about any plans that may affect the area.
Common mistake 4: Being too fussy about price
Not every property that you buy as an investment has to be a bargain. If you set your mind on only buying properties that can give you more than, say, a 10% return on investment, you run the very real risk of not buying anything, and missing opportunities to build up a substantial portfolio.
A well-engineered, prime property situated in a low-risk area is most probably not going to be priced at a bargain level, but as long as it is not overpriced, it will give a fair return on investment and can help form the backbone of a solid property portfolio, says Holland.
The bargain hunter will miss excellent buying opportunities of prime properties at fair market prices and run the risk of building a portfolio very slowly if at all. There are many investors in this hot market chasing prime properties for the yield so the bargain hunter or over pedantic buyer may be left with cash in the bank at low returns for a significant time period.
Common mistake 5: Gearing too high
Cash is king in any business, says Holland, and property investment is a business like any other. Buying a building with too much borrowed money exposes the investor to grave risk. The bond of the property has to be serviced by the operating income earned from the property. If this is too high, the failure of one tenant to pay his rent could jeopardise the whole investment.
Holland says there is no single rule of thumb to guide investors about how much money is prudent to borrow for a property investment; it depends on the reliability of the tenants and the vitality of the node. If the tenants include the branches of established, nation-wide companies, the buyer could borrow more, but if the tenant mix is made up entirely of small mom-and-pop stores, it is better to have a loan to value of 50% or less. The cash flow forecast, including bond repayments and tax, must allow for a realistic vacancy and arrear factor as well as for any short term increase in interest rates.
Holland urges prospective property investors to consider joining up with an established joint venture partner as a good way to start a commercial property portfolio. BUSINESS/PARTNERS, for example, are always keen to consider joint-venture proposals for property investments from entrepreneurs. The advantages go beyond the availability of finance, and include expert knowledge on due diligence investigation and assessing commercial nodes.
Most importantly, a joint venture partnership with an established property expert can teach you how to avoid the common mistakes without paying painfully high school fees.