Investing in property? Commercial is costlier, but delivers better returns

Investors can earn a steady 7-9 per cent rental yield in this segment, compared to only 2-3 per cent in residential

With the residential segment of the property market languishing, many high net worth individuals (HNIs) are now making a beeline for commercial buildings that have the potential to offer them steady rental returns along with reasonable capital appreciation. By opting for completed and leased buildings, these savvy investors are avoiding development risk - the risk of delay in delivery - that has marred returns in the residential segment. 

Robust demand

While the residential space has languished, demand for office space has been strong during the past four years. This year, about 33 million square feet of grade-A space has already been leased between January and September across the country’s top eight cities. This is a rise of 15 per cent over the corresponding period last year, according to Cushman & Wakefield India. “Office space take-up is being driven by growth in outsourcing (IT-ITeS) and services sector. India also has a fast-growing financial and banking services ector. It is also a key startup hub. New tech firms, and upcoming sectors such as e-commerce and coworking, have contributed to growth in office space demand,” says Anshul Jain, country head and managing director, Cushman & Wakefield India.

Demand has consistently outpaced supply in the recent past. “Today, any supply that comes into the market is leased out before completion or gets lapped up within a couple of months of completion, especially if it is a high-quality development from a reputed developer,” says Abhinav Joshi, head of research, CBRE India.  

Many corporates are currently reviewing their real estate strategies. “They are relocating and consolidating and taking up larger spaces to hedge against increases in rentals in the future, due to which this segment has seen significant price appreciation,” says Arpit Mehrotra, senior director, office services (Bengaluru & Hyderabad), Colliers International India.

More attractive than residential

The office segment is a more attractive proposition today for investors than the residential, where prices have remained largely stagnant or have declined. Investors who entered the latter segment in 2013-14 have seen negligible capital appreciation, while older investors have even suffered some capital erosion. “Project delays, especially in areas like the National Capital Region (NCR), have affected the returns that investors expected to earn from the residential sector,” says Joshi. For those wanting a regular income, the residential sector is not attractive as yields are low at 2-3 per cent. On the other hand, by investing in a pre-leased office property, investors can expect to earn a rental yield of 6.5-8 per cent, besides some capital appreciation, according to Jain.    

A commercial property is also more desirable from the perspective of longevity of the asset, as construction quality and maintenance are both better in these buildings. On the flip side, however, ticket sizes tend to be much bigger in the commercial segment, which means that only investors with deep pockets can venture into this segment.

Here are steps you might consider taking in case you are thinking of investing in commerial property.

Do the due diligence: Before betting on a developer, the investor must check out how many buildings he has delivered in the past, and whether he delivered them on time. Joshi suggests that an investor who is buying a pre-leased building should also check the quality of the tenants in it – whether they are top Indian corporates and multinationals – and the vacancy level within the building.   

Investors should also get technical due diligence done on the quality of the building. “What is the size of the floor plate? How energy efficient is the building? What is the quality of the generator set and air conditioning system that the developer has installed? Developers try to cut corners in these matters,” says Mehrotra. He adds that modern office buildings must also come equipped with amenities such as a food court, gym, creche, and so on.

Location is crucial: An office building should preferably be located in a in key office hub that is witnessing robust leasing activity. “Check the rental appreciation that has happened in the area in the recent past,” says Joshi. The area should enjoy easy accessibility.

What to avoid: Experts suggest that investors should avoid strata investing. This essentially refers to a small share (along with a large number of other investors) on one floor of a commercial building. “Such buildings have struggled to attract tenants in recent times,” says Jain. He also suggests avoiding poorly maintained buildings as they usually struggle to find tenants.    

Investors should also steer clear of projects that promise a guaranteed return. “If the yield that you can earn in a normal project is 7-9 per cent, it could be only 5-6 per cent in a guaranteed return project,” says Mehrotra. This happens because such projects are usually sold at a higher price to investors.      

Pros and cons of investing at different stages

• An investor who buys at the under-construction stage will enjoy higher capital appreciation once the building gets completed.
• However, such an investor also faces the risk of delays in completion. 
• An investor who buys at the second stage – a completed building that is not leased out – does not face development risk.
• However, he will enjoy lower capital appreciation than an investor who entered at the first stage.
• The key risk at the second stage is delay in finding quality tenants. 
• The safest bet is to invest in a building that is ready and leased out as the investor’s cash flows begin from day one.
• But a pre-leased building comes with tenant-related restrictions.
• The contracts have been signed with the tenants and the investor can't change them until a tenant’s lease expires.