What to choose: short-term agreements with the possibility to frequently reconsider the lease rates or long-term ones that protect against price adjustments?
In this article we will analyse the benefits of various types of rental agreements and offer you advice about real estate investment, giving you an understanding of what property is currently the most promising.
In the commercial property market, lease agreements can be short-term (1 to 10 years) and long-term (15 to 25 years). The choice between them depends on how the investor envisages the market climate over the subsequent years.
If the investor believes that rental rates are going to rise over the following 3–5 years, it’s better to put capital into the properties with short-term agreements. In this case, revenue can be increased through tenant rotation.
It’s not too difficult for experienced investors to calculate rental rate growth potential, but they should be ready to take on the risks involved. There is no guarantee that the rates will grow by the end of the rental agreement, nor that there will be a tenant who will pay more than the previous one.
With long-term contracts there is limited to no possibility of increasing the revenue if the rental rates grow in general throughout the market. However, if the investor thinks that there may well be negative price movements in the market in the foreseeable future, long-term agreements with no right to terminate or alter the initial terms accepted by the tenant will indemnify the investment against any decline in market prices.
As of 2017, prices in the EU and the US are already high, with there being no strong potential for growth, with it also being unlikely that mortgage rates will drop further. In such a market climate, we recommend that less experienced investors who want to keep their capital in real estate put such capital into projects with long-term lease agreements.
When investing in properties with 15–25-year agreements, investors should be expecting prices on the market to decrease during the first decade of ownership, as real estate market cycles alternate every 7–10 years. The price volatility will not affect the investor’s income: the terms of the agreement will not allow the tenant to terminate it prematurely or lower the rental payments. In such a case, the investor will be able to wait until the market recovers and exit the project under more favourable conditions. Moreover, long-term agreements can allow for adjustments to the lease price that reflect inflation increases.
What to invest in
In our opinion, investing in retirement homes, medical centres, warehouses and hotels shows the most promise today. They will not lose liquidity on a 15–25-year horizon (average agreement term for this type of assets).
Retirement homes and medical complexes will grow in demand as the population of developed countries continues to age, with life expectancy increasing. The rise in life expectancy will be boosted by advances in personal spending on new technologies related to medical services. According to UN forecasts, by 2050 over 40% of the population in advanced European countries will be over 60 years old.
Logistics parks will form the basis for online shopping. According to DHL estimates, cross-border shipping volumes for online retail are set to rise by 25% annually. As reported by Mintel, even close to 50% of Spanish, German and Polish nationals aged between 16 and 24 have bought groceries online in the 6 months prior to May 2016. This is only set to rise.
Lastly, hotels will remain liquid thanks to the fact that people will travel more frequently. According to estimates from the United Nations World Tourism Organization (UNWTO), the number of international tourist arrivals will be increasing annually by 3.3% on average up to 2030.
In our opinion, unlike the asset classes mentioned above, commercial property faces greater challenges that may decrease its liquidity.
As freight transport becomes cheaper, online sales will grow sharply. Such a growth is likely to be facilitated by doing away with manual labour and replacing it with autonomous machines and robots that fill and deliver orders. This will reduce cost and delivery times, thereby tipping the balance significantly towards electronic retailing. At the same time, the demand for conventional shops will decline.
How to invest
Although logistics and medical centres demonstrate potential, we recommend investing primarily in retirement homes and hotels with strict 15–25-year agreements. These options are perfect for investors who prefer simple rental business and live far away from the property which they have placed capital in. The entry level for this type of investment starts at €10M, with a yield of 4–6% per annum.
As for clients with smaller budgets, we recommend buying separate rooms in retirement homes or micro-apartments to be leased out over the medium and short-term. The entry level for this type of investment starts at €100,000.
When investing in retirement homes we recommend:
- selecting reliable markets: Austria, UK, Germany, USA or France, and in large or medium-sized cities and their suburbs with well-developed infrastructures;
- selecting the right property micro-location. The main question investors should be asking themselves is whether there will be many retiree tenants in the area in 10–30 years’ time (during the rental agreement and after its expiration). This information can be obtained during the project audit;
- estimating the possibility of upside, in other words, the hypothetical possibility of expanding the room capacity and consequently increasing the revenue and capitalisation;
- investing in new-builds or renovated buildings that meet the tenants´ requirements
When investing in hotels we recommend:
- considering such investment vehicles as large hotels in popular locations;
- investing in mini-hotels cautiously and selectively since they are often managed by minor operators, which may lead to their failure to fulfil revenue plan and rental agreement obligations;
- selecting hotels in large cities with big tourist flows, independent of seasonal demand;
- paying attention to the hotel condition, the time it was last renovated, its ratings and reviews on the internet, the tourist flow in the area where the hotel is located in the city, demand seasonality, the hotel´s competitive ability in the local market and the local infrastructure.
A property with a long-term lease agreement is the equivalent of a bank deposit in the real estate market.
We recommend paying special attention to the two following things when making such an investment:
- who guarantees the rental flow payments – Joe Bloggs Ltd. or a large company whose bankruptcy risk is low;
- how the location will be 20 years after the agreement expires. As one of our clients once said: “If everything is going well with my tenant´s business and they have many clients, then I will be the king when the lease expires and be able to dictate the terms by which the tenant will extend the lease agreement with me.”