For a commercial property investment to be a success, you need to put a microscope over the finer details… before you buy. Here is part one of our key due diligence tips for purchasing commercial real estate.
After your offer to purchase has been accepted and you’ve shaken hands with the vendor, you’re arguably on to the most important stage of a commercial property investment… The Due Diligence period.
Due diligence is critical to the success of your investment. The pre-purchase investigations will help uncover any nasties that might plague the asset in years to come. And a microscope over the fine print could allow you to see opportunities that unlock maximum investment potential.
The value of due diligence is usually seen months or years after an acquisition, so being meticulous from the start is essential to brightening your investment’s future.
Review the lease expiries
The value of your asset is significantly dependant on the lease agreement you have with your tenants. So, one of the most crucial aspects of your due diligence efforts is being aware of any approaching lease expiries.
If a lease renewal is coming up, you might soon be preparing to find a new tenant. This can hinder your investment. Or it can help it, as a vacancy might be an opportunity to increase the value of your tenancy schedule by finding a higher quality business to lease the premises.
As you’ll have no way of knowing the quality of the last due diligence on the property, it’s important to review the existing tenancy schedule. The current tenants should have a solid payment history and might ideally be a national or multi-national business.
This is also a great opportunity to assess what could happen to the property should the primary or anchor tenant vacate. What customers would they take with them? How will this impact the remaining tenancies?
Tenants are the backbone of any commercial property, so running every what-if scenario is critical.
Discover what has been spent on the property
During a commercial property’s lifetime, its total return will be eroded by hidden capital expense items. These expenses – which can include anything from roof repairs to new bathrooms – tend to reappear during the lifespan of a building, so it’s vital to look at what upgrades and maintenance will be needed in the next few years.
The way to do that is to understand what recent CapEx improvements have been made by the owner.
Recent repairs, renovations or fit-outs on the premises shows that the landlord has put in the effort to maintain the property’s value. On the other hand, if minimal improvements have been made in the last two or three years, the asset might have seen neglect.
If the property has been managed inattentively, expect some outlays to bring it up to scratch or to replace any aging fixtures, like air conditioning or alarm systems.
It’s important to measure where you will gain the most value from capital expense items. Generally, there are market trends which can be studied to help you uncover what the current tenant market is looking for.
For example, some logistical businesses and manufacturers are seeing a clear drift toward automation and technology advancements to meet customer demands. This has changed the CapEx environment for industrial property landlords, who now need to understand and respond to evolving tenant needs.
Market drivers and trends will affect whether your upgrades are meeting tenant market demand. So, it’s important to understand the market where you can. To avoid a misguided decision and help you cater to tenant needs, make your property improvements based on another crucial due diligence tip: firm market research.
Understand the leasing market
Research the current leasing market so you can find out how deep occupier demand goes for your chosen asset class. You can then appeal to those who are looking to lease.
And if you lose a tenant, or already have a vacancy, do you know how easy it will be to find a replacement? The key to figuring this out is looking at the vacancy rates in a segment.
Low vacancy rates can be a sign that market conditions for businesses are good. Healthy businesses and start-ups begin to expand or upgrade, and this leads to demand for space. It can also mean that there’s an under supply of available premises in the market (be wary of paying a premium for your property if this is the case, as low levels of supply push up property prices).
Businesses compete for rental space when vacancy rates are tight and usually this will increase the rent that landlords can charge.
On the other hand, high vacancy rates either mean that there’s an oversupply of similar properties in your market or that businesses are struggling. Less are looking for space to occupy, so landlords will offer incentives and reduced rents to attract them.
Keep an eye out for a drop in vacancy rates too, as this usually makes a good bet the rental market is improving.
Research threats in the market
Your due diligence should include scanning the drivers in the external environment. This means seeing what new additions to the market might threaten your investment.
Emerging supply into a leasing market can drive down rents for landlords. New properties dilute the market demand for space, giving renters more choice of where to occupy – and property owners less income. This threat of oversupply can be seen in markets with high vacancy as we’ve discussed above.
For landlords of older buildings, their capital expenditure is likely to go up, as they’re pushed to improve dilapidated structures and fixtures to remain competitive.
Talk to existing tenants
During the due diligence phase, tenants are likely to tell you all of their gripes. And as a potential buyer of their premises, this can be revealing – you could be buying their problems too.
For instance, a tenant might tell you that the premises is too small for their needs and that they’re bursting. Unless you can offer an extension to their net lettable area, or provide an alternative occupancy arrangement, you could see them relocate at the end of their tenure.
Showing your willingness to listen can help in the long-term of your investment too as tenants who feel looked after and have their needs met will be more likely to stick around.
An interpersonal approach with existing tenants will give you good insights to consider how likely they may be to renew their term, or what opportunities might be available to strengthen your new investment.
Due diligence is a necessary part of the acquisition process. It will help your real estate investment shine in the years after your successful bid by revealing avoidable issues and uncovering robust opportunities. For a reliable commercial property investment, it’s imperative you do the hard work from the start.
Keep an eye out for part two of our key due diligence tips for buying commercial property.
For more information on how to invest successfully in Australian commercial real estate, contact HRB & Co Property Advisory today.
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