Commercial property offers returns

Global warming is changing commercial property building.

Both tenants and owners are now showing their preferences for Leadership in Energy and Environmental Design (LEED)-certified buildings.

Large, multinational tenants like the structures because their energy- and water-saving features reduce operating costs, says Bob Levine, principal of Avison Young, a commercial real estate services firm. And, rising tenant demand for this type of space means owners can charge more rent.

For instance, one of the most sought-after LEED-certified office buildings in Vancouver is the Bentall V, which is generating net rent of about $40 to $50 per square foot, per annum. Real estate investment advisor Bentall Kennedy owns it.

In addition to base rents, tenants are still responsible for operating costs, which could add about $20 per square foot, per annum, says Levine. The average commercial office building in Vancouver generates between $30 and $35 per square foot, per annum.

There’s one caveat to LEED certification for commercial properties, however: it’s only catching on among renters of office space, where operating costs are historically five to 10 times higher than industrial facilities, says Levine.

LEED isn’t catching on in the retail space either, he says, because most shopping centres were built decades ago and there hasn’t been a lot of replacement.

“These will remain popular because they’re in major cities. So while owners might do some upgrades to be more energy-efficient, they won’t replace a major shopping centre.”

3 tips for commercial property investors

• Focus on the sustainability of the annual returns.
• Don’t put too much weight on capital appreciation because a lot has already been incurred.
• Look for a property management company with a good track record.

Source: Bob Levine, principal, Avison Young

Joe Genest, associate, Investment Division, Colliers International, agrees office space will retain the edge, especially in green-friendly markets like downtown Vancouver. “In the next five to seven years, you’re going to see a number of new buildings—all LEED-certified,” he says.

Levine adds that the major owners of LEED-certified office space are public pension-fund companies such as the Ontario Teachers’ Pension Plan, which owns Cadillac Fairview, a real estate investment and development company.

Commercial by region

Canada’s major cities have produced positive commercial property returns, even exceeding those of other investment areas worldwide, says Levine.

“In Calgary there’s been a lot of fundamental growth. Rents have increased and cap rates have decreased.” (See “Average cap rates,” below.)

Average Cap Rates

Downtown office (Class A)
City	Low	High
Vancouver	4.75%	5.50%
Calgary	5.25%	5.75%
Edmonton	5.5%	6.5%
Toronto	5%	5.5%
Ottawa	5%	5.5%
Montreal	5.75%	6.5%
Winnipeg	6.5%	7%
Halifax	6.25%	7%
Industrial (multi-tenant)
City	Low	High
Vancouver	5.5%	6.5%
Calgary	6%	6.5%
Edmonton	5.75%	6.5%
Toronto	6%	7%
Ottawa	6%	6.5%
Montreal	7%	7.75%
Winnipeg	6.75%	7.5%
Halifax	7.25%	7.75%
Retail (regional)
Vancouver	4.75%	5.5%
Calgary	5.5%	6%
Edmonton	4.75%	5.75%
Toronto	4.75%	5.75%
Ottawa	5%	5.5%
Montreal	5.75%	6.75%
Winnipeg	6%	6.5%
Halifax	5.5%	6.25%

Source: Colliers Canada

Meanwhile, Vancouver’s commercial property prices have hit all-time highs, making it difficult for many investors to enter the market (in Q1 2013, the Canada Post building in downtown Vancouver sold for a record $166 million, or $241.98 per square foot, finds a report by Colliers Canada).

“There’s a lack of product, an abundance of demand and low interest rates, which has caused compression in capitalization rates and land values,” says Genest.

This trend is true for all of B.C.’s major cities. For instance, tire dealer Kal Tire is the sole tenant of a property in Cloverdale, a suburb of Surrey. The building owners put the property up for sale, he says, and received offers within days—two above asking. “Investors were calling and demanding to know how to get the asset.”

Full details aren’t available because the sale’s not yet closed, but Genest says the asking cap rate was 5%.

He advises investors who want B.C. commercial properties with name-brand tenants (e.g. McDonald’s, TD Canada Trust, Shoppers Drug Mart) to have all their financing lined up ahead of time. “You’re going to have to come in with the shortest amount of conditional time possible.”

And, “because of cap rate compression, we’re starting to see local and regional investors looking out-of-province, where they’re getting slightly higher returns.”

Commercial by property

Apartment buildings have historically done well to generate income streams because there’s a lack of new supply—little new stock is being built.

“They’re hard to come by, so owners have not suffered vacancies, which can be a major drag on returns,” says Levine.

But these properties still have lower overall returns compared with commercial space. He notes a shopping centre in Vancouver could get a 6% return, an office building 5%, while apartments might get 3.5%.

“Even though they’re reliable rental streams, the returns are lower so investors must hold for the long-term.”

Levine adds the B.C. rent control regime is weak, “so owners don’t worry about it. Rents gradually increase with inflation, but if you upgrade a building or a tenant moves, then you can substantially increase the rent.”

Meanwhile, he says, “office has also been a strong performer in recent years, but that may change as new supply enters the market in most major cities.”

Investors choosing office should look for properties close to rapid transit, as these buildings outperform suburban counterparts.

In retail, one option is U.S. grocery stores, which are getting investors growth and yield.

“Slate U.S. Opportunity funds buys grocer-anchored malls in mid-sized cities in primarily the northeast U.S. to the top of Florida,” says Craig Machel, portfolio manager, investment advisor, Macquarie Private Wealth. “They’re buying at low rates, primarily occupied, and are in cities that aren’t necessarily expanding with more mall growth (e.g. Pittsburgh, Pennsylvania and Charlotte, North Carolina). So the risk of these malls becoming defunct is low.”

The funds were a one-time offering, however, and are currently closed, says Machel. This is because Slate wanted to provide zero liquidity to keep the share price stable. This way, investors won’t see capital depreciation, as sometimes happens through a typical TSX offering.

He adds that Slate continues to explore investment opportunities in the U.S.

Generate an income stream

The reason most people hold on to commercial property is the cash flow and rental income. It’s the payoff for conducting painstaking due diligence and meticulous deal structuring, and ensures long-term profitability comes from potential price appreciation of the real estate asset, as well as the net rental income. This is often referred to as the capitalization rate.

The key is to earn more rental income than it costs to finance the property. So if you’ve got a $7,000 monthly mortgage on a building, you want rents that pay more than that, plus a cushion to cover unexpected expenses like maintenance.

And keep the portfolio balanced with other investments, including equities.

Sources: David Sung, president of Nicola Wealth Management; Wayman Crosby, CEO of Nicola-Crosby Real Estate Investments Ltd.