Commercial real estate offers higher rental yield, but beware the risks

Investors much conduct their own rigorous due diligence before investing to mitigate risks from this segment

Delhi-based couple Jyoti and Rishi Arora recently chose to invest in commercial property, attracted by higher rental yields and the prospects of capital appreciation. They selected a 250-square-foot office space priced at Rs 80 lakh. “After extensive research, we selected a project in Sector 140, Noida, developed by a reputable builder,” says Jyoti. The presence of major IT companies in the area has strengthened their confidence in this investment.

 

Advantages of commercial real estate

 

Commercial property offers diversification beyond residential real estate. If occupancy rates are strong, it can deliver higher returns than residential rental assets. “Typical lease terms in commercial real estate are long-term, unlike the one-year rental agreements common in residential properties, thereby ensuring stable returns,” says Vimal Nadar, senior director (Research), Colliers India. 

Commercial properties typically offer higher rental yields than residential properties. “The rental yield can be around 5-7 per cent annually in commercial real estate compared to around 3 per cent in residential,” says Smita Patil, managing director of SSPL Group and president of Naredco Mahi. 

Investors can also benefit from capital appreciation, which would typically range from 7-10 per cent per year.  “Invest in a space that has already been leased by the developer. Returns can vary widely, depending on the location, purchase price and timing of purchase,” says Salil Kumar, director marketing & business management, CRC Group, a National Capital Region (NCR)-based developer.

 

Risks and challenges

 

A significant barrier to entry in commercial real estate is the high initial investment. Another risk is property vacancy. “Your returns could be affected if a tenant vacates and a new one is not found soon,” cautions Manoj Dallal of Shivsan Buildwell, a commercial real estate broker. Vacancy risk became evident during the pandemic when many companies reduced the office space leased by them due to remote work. 

Day-to-day property management is another challenge. “Finding and managing tenants, maintaining the property, and so on are issues that retail investors might find difficult to grapple with,” says Dallal. Furthermore, market conditions can cause fluctuations in property value, affecting exit timing.

 

Overcoming high-cost barriers

 

Retail investors can consider grade B properties if they find grade A projects unaffordable. “Not only are these properties more affordable, but if chosen well, they can provide higher returns,” says Bappaditya Basu, chief business officer, Anarock Commercial. 

However, such properties may attract lower-quality tenants, and require higher maintenance. 

Fractional ownership offers an alternative investment option. Say, with Rs. 1 crore each, investors can form a limited liability partnership (LLP) to co-own a Rs 10 crore property. “If one investor decides to sell their share, the remaining partners typically purchase his stake,” says Patil. 

Many platforms facilitating fractional ownership have mushroomed. “The leading platforms in India typically require a minimum investment amount of Rs 20-25 lakh for commercial properties,” says Nadar. He adds that regulatory measures by the Securities and Exchange Board of India (Sebi) to promote small and medium real estate investment trusts (SM-Reits) will streamline such investments and increase retail participation.

 

Investing in Reits and SM-Reits

 

For retail investors, real estate investment trusts (Reits) and SM-Reits have lowered the entry barrier for commercial real estate. “Reits and SM-Reits facilitate retail investor participation in commercial properties with relatively small amounts of investment, and they benefit from both capital appreciation and dividend income,” says Nadar. 

Minimum subscription for SM-Reit IPOs is Rs 10 lakh, while Reit lots are priced between Rs 10,000-15,000. Post-listing, both Reits and SM-Reits can be purchased at market rates. 

“Investors in SM-Reits can expect pre-tax returns of about 9 per cent per annum and year-on-year appreciation of around 5 per cent,” says Umesh Sahai, chairman and managing director, EFC (India). He adds that in the worst-case scenario, SM-Reits can liquidate the real estate and repay the investment made by investors.

 

Due diligence is critical

 

Investors must conduct thorough due diligence before investing directly in commercial property. “Evaluate the developer’s brand standing, credibility, the quality of the catchment, and the type of tenants it attracts,” says Basu. 

Choosing properties in areas with strong infrastructure and growth potential can help ensure stable returns. Investors should also assess rental demand, maintenance costs, and resale value. 

Legal due diligence, assessment of the property’s condition, and timing entry and exit correctly are critical steps, according to Dallal. 

Basu recommends a minimum investment horizon of five to seven years. “This allows time for appreciation in property value, stable rental income, and recovery of initial costs,” he says.

 

Common mistakes to avoid

 

Investors should understand the demand-supply dynamics of the locality before investing. “If you are leasing out the property, understand the nuances of the lease agreement. Also, do not underestimate maintenance costs, which can erode returns,” says Dallal.

 

Pros and Cons of SM REITs

 

Pros

Investors can select schemes based on properties they prefer, unlike traditional REITs where properties are pre-selected by the investment team

Investors receive quarterly rental income and potential capital gains on sale after 4–6 years.

Listed units provide exit for investors via stock market.

Promoters must invest 5 per cent of capital, aligning their interests with investors.

Commercial assets in SM REITs can offer rental yields of 7-8 per cent or more.

Annualised capital gains on property sales can range from 5-6 per cent.

 

Cons

 

Properties are leased at the time of investment, but tenants may vacate after lock-in period

Changes in property values can impact price of SM REIT units on exchanges

SM REITs are a relatively new asset class

Investment managers may face challenges in finding new tenants if market conditions worsen

As a new product, SM REITs may have lower liquidity compared to established REITs

Oversupply of similar properties in the market can increase tenant turnover risk

(The writer is a Delhi-based independent journalist)