As we all know that the main reason why a person invests in a commercial property is to eventually rent it out and get returns in the range of 6-8 % per year as regular income. Expected returns from a commercial property are always higher than an investment in a residential property where they are in the range of 2-4%, although the appreciation in the value of commercial office property is rarely as high as a residential property.
Although, we know that 6-8% is the ideal range of returns from a rented commercial property but we do have deals available at 10% return and properties trading at as low as 4% as well. To understand how this happens we first of all let us understand a couple of terms first is intrinsic value of a property , it is nothing but the actual market value of the property at which it or a comparative property is sold if it was not leased, which can be gauged easily by finding comparative rates in the same building, locality or street etc .
Second, whenever we are talking about return from a commercial property is basically the rent we get from it when we lease it out ( like we get interest from our money kept with a bank ).So the reason because of these aberrations take place is the difference in rentals in different market situations.
Now let us try to evaluate this with the help of a couple of illustrations and analyze the situations that which help them arise- Is the rent of the property in the range of market ?
Let us take example of Sohna Road in Gurgaon where the price of bare shell commercial office space is in the range of Rs.8000/sq ft –Rs.8500/sq ft . Now for the sake of illustration we will take a situation where a property on this road has been lease at two different lease rates, one where it has been rented at Rs 65/sq ft and in the other case it has been rented at Rs 40/sq ft . What we will see is that we had to go only by the return we are getting from the property than we will see very huge difference in the price of the same property.
Say I am getting a return of 7% in both case than
In case one where the rent is Rs 65/sqft the price of the property will be Rs.11,142/sq ft.
In case two where the rental is Rs 40/sq ft the price of the same property will be Rs.6,8571/sq ft.
This clearly shows that there is something wrong in buying a property only on the basis of percentage return offered by the seller. The intrinsic value of the property is about Rs 8000/sq ft if I say that because it is already leased I should pay a premium in the range of 15-20% depending on various factors( refer the article ) , the price I should pay for it rationally should be around Rs.9,200/sq ft to Rs.9600/sq ft , hence to get the best deal I would like to pay only about Rs.9200/sq ft . In the first case if you get this property at a high return of around 8.5% i.e @ Rs 9176/ sq ft it is closer to the actual market value, at the same time in the second case even if you get that property at a return as low as even 5.2% i.e @ Rs.9200/sq ft it is close to the market price.
So keeping other things constant , it is ok to assume that if a property is available at a higher return than it must have been rented at a rent higher than the prevailing market rental .
Likewise, Its also okay to buy a property at a lower return if it has been leased at a rental lower than the prevailing market rental in the area.
Now that we have understood HOW it happens let us understand WHY does it happen– Why do people knowingly pay a higher price for a property when a similar property is available at a lower rate or in the other situation why do they agree to take a lower return on a property when a similar property is available at a higher return.
1)Why should we buy a property giving us a lower return ( because the price of the property will be low and you get a better appreciation in longer run .. ideal for people in middle age group who are looking at low regular income ( as they are themselves earning at that point of time ) with high potential for growth ( may be the retirement kitty, children marriage, higher education of children etc).
2)Why do people pay higher value of the same property (because I am getting a higher return). This is ideal for retired folks who only very higher returns (they is not working and not sure about how long will they be able to enjoy the benefits of the property , not at all concerned about the long term appreciation of the property they would rather want the highest income than can be generated from whatever they have so that they can use it to travel, to pay for their hospital emergencies etc).
One should always consult their property adviser to guide them the best buy according to their requirements.- age group, risk taking capability, requirement of liquidity etc etc.
Bottom line is that not every shoe is for every person, one has to look for one according to their preferences and requirements.