Falling interest rates, increasing vacancies and rising values for health care assets have created the perfect property storm for health care business owners to purchase their place of practice rather than rent.
Clearly there are advantages to being your own landlord but other than enjoying the security and control of the tenure of your tenant (ie: you!), there are a number of benefits associated with owning a commercial site.
Better cash flow and an exit strategy
With interest rates at an historic low, paying a commercial loan is actually more cost effective than paying rent. Plus, having the ability to set the rent within market parameters may save you tens of thousands of dollars a year. As the rental income pays down your debt, the rent becomes passive income once the debt is paid.
Since you are the landlord, the ability to sublease extra space is much easier, helping with cashflow and allowing you to flex up or down as your business changes.
You also have the option to sell the business and retain the asset in retirement. Like many doctors and health care specialists, you may continue to work in some format albeit without the accountability of managing a whole practice.
The value of a medical tenant
Commercial property is not valued in the same way as residential property. The rental income, length of lease and quality of tenant play a major role in the valuation of a commercial site. If the property is vacant, the land and building rates are taken into consideration as liabilities which lowers the value of the site than if it had a tenant. The guaranteed upside here is that you secure a vacant site at a reduced rate which you then tenant and immediately increase the value of the property. Your asset has instantly appreciated just from having you as a tenant.
Another lesser known fact is that not all tenants are valued equally. A real estate agent, beauty salon or wine bar doesn’t carry the same weight as a medical tenant. Why? Because medical is perceived as a sector with strong goodwill within the community and, as a result, the chance of vacating the premises is much lower. Plus, they are often low risk tenants and are unlikely to default or break a lease. They are also highly qualified and have resilient business models, backed by Medicare, in an expanding and under serviced sector viewed as recession and pandemic proof.
Before we workshop an example, let’s explore some common commercial property terminology.
Capitalization rate, commonly known as cap rate, is a rate that helps evaluate a real estate investment by showing the potential rate of return on the asset. The higher the capitalization rate, the better it is for the investor. The cap rate is calculated by dividing a property’s net operating income by the current market value. This ratio, expressed as a percentage, is an estimation for an investor’s potential return on a real estate investment
WALE, or weighted average lease expiry, is not a misspelling of a marine mammal but a common and important term in the world of commercial property. The WALE is a way of measuring the average time period in which all leases at a property will expire.
Lessor is the entity that owns the property, also knows as a landlord.
Lessee is an entity that holds the lease.
Lease term is a duration set out in the lease that dictates the minimum amount of time a tenant is expected to remain at the site. Lease terms can be renewed after the full term is complete, however, there’s usually a penalty for terminating a lease before the completion of the full term.
Net Lettable Area (NLA) is a measurement of the total occupiable floor space taken from the inside surfaces of the exterior walls and/or the mid-line of any shared walls and excludes areas such as common stair wells, communal toilets, lift lobbies and vertical service ducts.
Once we know the ‘cap rate’ norm for this style and location, we can form an opinion on its value. Bear in mind, a vacant building is valued on a land and building rate which is always far lower than if tenanted. This is the upside mentioned earlier.
The market cap rate for health care assets is currently sitting at 6-7 per cent for strata properties and 4.5-6 per cent for freehold (depending on a number of factors, such as length of lease, quality of tenant and location).
In this case, it’s a freehold building and we’re basing our estimates on a cap rate of 5 per cent. $100,000 divided by 5% gives us $2,000,000 as a very broad value range.
Considerations include the zoning, future development scope or ability to increase the NLA. If the site is occupied, you should also investigate the tenant’s fit out expenses and whether they have a ‘first right to buy’ clause in the lease.
Now, let’s consider the same building has the same terms but with a different business operation such as beauty, trade supplies or real estate. In this case the cap rate would be closer to 6 per cent.
$100,000 divided by 6% = $1,666,666.7
Same building. Same location.
The COVID effect
The commercial property market, like many others, has been forced into a confronting and sudden change. Strong opinions constantly swirl as to whether there is even a place for suburban retail anymore with strong growth in e-commerce or if the corporate world needs their monolithic CBD offices now that employees have adjusted to – and are happier – working from home. The sector is seeing vacancy rates climb and small businesses and landlords are nervous about what kind of ‘covid normal’ future lays ahead.
The commercial office space in Melbourne was experiencing all-time lows of around 3.5 per cent prior to the onset of COVID-19. This number has since increased to over 10 per cent. Sydney is very much the same and with a strong supply pipeline, this will likely increase. Increased vacancy usually means reduced rents and as we know from the above scenario, reduced rents mean property values take a hit.
Beware the ‘Seasoned Investor’
Your nemesis when securing a property for owner occupied reasons is ‘The Seasoned Investor’; the person in it purely for the rental returns and appreciation on the asset. Commercial property is seen as a great long-term investment and experienced property investors generally turn their attention to commercial property once they have established a residential portfolio, sold a business or come into some cash. This helps to ensure the bank’s lending requirements are met, as lower LVRs of around 60-70 per cent are the norm since most investors will put up a lot of cash up front to keep repayments low and increase cash flow or reduce the financial burden if the property is vacated.
However, recent data suggests these types of investors are slowly dropping out of the residential market and this will also flow into the commercial market. According to the latest ABS housing finance data the portion of finance given to investors for residential property investment fell to a record low of 23.5 per cent in August. This is significantly lower than the decade average of 36.1 per cent although NSW has experienced the greatest drop with a 28.2 percentage point drop since 2014 when investors accounted for 55.6 of the loans issued by financial institutions.
Put simply, the TLDR wrap is:
An opportunity not to be missed for those in a position to take advantage of it.