Was it easier back then?

Aspiring young investors building a commercial property portfolio often ask me this question. The answer is simply yes.

Twenty-five years ago, banks, insurance companies, and tenants were not concerned about a building’s seismic rating. It was simply never raised. None of the parties felt the need to obtain an asbestos survey report. Different story today.

Banks were willing to lend up to 70% of the purchase price. Today, it is slightly lower, around 65%. However, the ICR (interest coverage ratio) now applies, which, in some cases, limits the percentage of the purchase price that can be borrowed, reducing it to below 65%. The ICR was not applied 25 years ago.

Rates and insurance costs were not significant factors. Allowing for inflation, they were not at the high levels they are today.

Looking at Wellington at the turn of the century, it was possible to buy good industrial investment properties at yields of around 11%, while mortgage interest rates for commercial real estate were around 9%. Today, yields are around 7%, and mortgage interest rates are circa 5.5%.

Not much has changed in the gap between yield and the cost of funds.

Let's look at a possible scenario.

Assume a good industrial property with a strong location, tenant, and lease generating a net rental income of $250,000. Back then, it would have sold at a yield of about 11%, equating to a value of approximately $2.3 million.

The same property today would sell at around 7%, valuing it at $3.6 million.

The return on equity.

Purchase price 25 years ago: $2.3 million (11%)

70% mortgage = $1,610,000

Deposit required = $690,000

Positive cash flow, rent of $250,000 less mortgage interest of $144,900 = $105,100

Return on equity = 15.2%

Purchasing the same property today:

Purchase price = $3,600,000

65% mortgage = $2,340,000

Equity required = $1,260,000

Positive cash flow, rent of $250,000 less mortgage interest of $128,700 = $121,300

Return on equity = 9.6%

The 15.2% simply comes from the higher yield. If compared to an interest rate of 9% this is 1.7 times higher. Applying the same to the 9.6% and an interest rate of 5.5% the rate is also 1.7 so nothing has changed here.

The deposit.

Using the sample above it was $690,000 25 years ago now it is $1,260,000 however applying compounded inflation over the 25 years $690,000 in today's terms is $1,300,000.

You can see from the above that from the financial side, it is no harder buying an investment property today than it was 25 years ago.

In summary, I do however believe it was easier 25 years ago:

• Seismic and asbestos issues were not really a factor

• There was less legislation governing commercial properties and protecting occupiers

• Obtaining insurance was easier

• Positive cash flow was higher due to higher yields

• Rates and insurance were more manageable, which was very important if a property became vacant

  
  

However, we live in today's world, and when I look at successful investors who continue to grow their portfolios, I see that they buy well-located, low-maintenance properties they believe will always attract tenants.

They are driven by two factors:

• the positive cash flow and a high return on their equity, achieved by buying properties at yields above the cost of borrowing,

• they buy below replacement cost. They know that building costs will continue to rise, meaning the gap between new and existing buildings will grow, and therefore, rents will continue to rise.

If you would like to discuss your commercial property investment strategy or current rental returns, please feel free to get in touch.