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Red Flags To Be Aware of Before Investing In Commercial Real Estate
"An investment is one which, upon thorough analysis, promises safety of principal and a satisfactory return”
-Benjamin Graham in his book Security Analysis published in 1934.
Here he speaks clearly of the two basic criteria which one should look at if an opportunity is to classify as an investment in the buyers portfolio. Real estate has time and again been used to balance out portfolios and are looked upon as investments with a rather steady return with reasonable capital appreciation. While that holds true for both residential and commercial, the risk and reward ratio drastically increases when we consider CRE. While residential allows us gather a 2%-3% rental per annum we can see anywhere from 6%-10% yields in commercial projects with the escalation not being accounted for, but this path has its own risks. It is an absolute necessity to go over the probable hindrances and red flags so that we can avoid them and safeguard our hard earned capital.
1. Extremely high rentals :
Writing this may sound unintelligent as a buyer’s mind is always in pursuit of high rentals, however, we need to look past this. Higher than market rentals could sometimes mean that the property itself is overvalued and the scope for appreciation is less. To gain we need to ‘buy low, sell high’ but if we buy a property at a pre-existing high, it means that it’ll take a longer time for us to realise a gain on capital appreciation and the gain would be a lower percentage than the properties in the same area.
2. Scope of development in the area:
Great and well known areas are often a building block for trust in the project but we need to consider how much the project has to offer on a long term basis. If the scope for development is low and the area has already proven to be a fruitful market, then there is a saturation point that it is fast approaching. Which means that the scope of development is reducing and if viewed from a broader perspective we will notice the project is not able to provide sizeable appreciate to the investor’s property.
3. Short lock in:
Fresh lease: Among various aspects in a lease agreement there components such as tenure and lock in period. Lock in period is the time frame in which either party is heavily penalized if they intend on leaving or evicting the other party. This usually works as a safety for the investor as the tenant practically is securing the rental for at least this time frame. However if a fresh lease has a very short lock in period, it fails to establish trust and investors should stay wary of such agreements as the intentions of the tenant are unclear in this situation.
4. Credibility of the developer:
Developers who undertake large commercial projects are usually old and established with a certain reputation in the market. While some developers might have an excellent track record of delivering projects and executing tenant deals, others might not. These developers often in search of more inflow start selling projects based on models and speculations. They lay a subtle honey trap to bag investments and execute the deals in their favor. Hence in these cases it is beneficial to take a look at the status of the previous projects and the status of investors in that project and then put our faith and money into a project.
Investors always look to real estate as a high return avenue and that should not stop. The above mentioned red flags are just listed to give you a better idea on what aspects of a certain project can be reviewed in the best interest of the safety and probable return. Concluding I’d say, as with any investment, risk is going to be a part of the property and the goal is to acquire a safe and profitable one. So if we know which red flags to look for, we can save our energy and devote our resources to better and safer projects.