Commercial Realty: A high return yielding instrument in a low-interest regime

February 19, 2021 12:12 PM

An investment in Grade A commercial premises may be one of the safest bets for a risk-averse investor.

In addition to rental yield, real estate is subject to another form of returns through price growth.

The performance of any financial asset or investment can be evaluated with the help of some basic financial principles and ratios, with a very conclusive outcome of a quick study. This article attempts to make a case as to why real estate is the optimum asset class to invest in, given the current market circumstances, and from the two categories prevalent in urban India, why commercial real estate is better than residential.

Higher rental yield

Real estate, in urban price buoyant India, is a low-risk medium-term asset class. So, comparable investments would be Fixed Deposits, GoI/ Municipal Savings bonds and Corporate Debt. Equities are much riskier than real estate or FDs and bonds, evidence of which is regularly observed through the high volatility of the benchmark indexes.

First, let’s look at the prevailing rates for a minimum 3-year investment in bonds and FDs. Currently FDs are being offered at 5.50% p.a. with further easing on the horizon which may push these even further down to 5.25% in the near term. After tax, this works out to a net return of under 4%.

Now, let’s look at Mumbai real estate for a closer study. The average property, at 27,000 psf, yields anywhere between Rs 85 psf and 145 psf through rent, depending on whether it is residential or commercial real estate, and other qualitative aspects of the property in question. Factoring in average maintenance costs of Rs 15 and 25 psf, adjusting the price for stamp duty, variable GST and considering an average deposit of 6 months rent, and then taking into account the tax abatement available for House and Property Income, the pure rental yield, net of taxes, would be between 2.34% and 3.80%.

Better capital appreciation

In addition to rental yield, real estate is subject to another form of returns through price growth. CEIC data on nominal price growth of residential real estate reflects an average annual appreciation of property between 2010 and 2020, to be 13.06% p.a. The all-time low of this index, recorded in 2019, was at 3% p.a. Now considering that the curve has bottomed out and real estate prices are at an all-time low too, an annual rate of price growth of 7% is in line with the 3-year outlook on real estate price growth in dense urban markets like Mumbai.

Now even if this rate of price growth seems high, the lowest annual appreciation recorded till in the last ten years was 3%, in Dec 2019, which if considered, would make real estate a better performing asset class than FDs. With the rental yields superior in commercial real estate, and taking into account the principles of value investing, an investor is likely to have a lower pay back period as well as better cash flow cycles where the annual yield or pay-out is higher.

Robust outlook

Commercial Real Estate is forecasted to have robust demand because of the proliferation and recent successes of REITs as well as natural market demand resulting from lower supply than absorption levels identified hereabove. REITs are likely to purchase commercial real estate, especially portfolios of Grade A premises, at benchmarked rental yield rates, bringing much-needed exit strategy certainty for property investors.

Active meaningful policy intervention by the government like reduction in stamp duty in Maharashtra stance indicates further easing for commercial real estate. PM Modi giving a clarion call of AtmaNirbhar Bharat, and attractive PLI schemes for domestic manufacturing will stabilize demand in the sector.

In conclusion, an investment in Grade A commercial premises, especially in micro markets where commercial property is in short supply, and in prime locations, is the safest bet for a risk-averse investor.

(By Krish Raveshia, CEO, Azlo Realty)

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