10 smart ways to avoid strata trouble

Investment in strata offices, shops and factories can be a wild, profitable ride – but there are safety measures you can take to iron out the bumps. By MICHAEL LAURENCE.

By Michael Laurence

Investment in strata offices, shops and factories can be a wild, profitable ride – but there are safety measures you can take to iron out the bumps.

SME owners wanting alternative property investments to residential properties or sometimes-volatile listed property trusts may be tempted to invest in small commercial properties. But take extreme care; this is a high-risk sector with plenty of traps for the uninformed.

 The investment prospects of a quality strata office in an excellent location and with a solid, long-term tenant are far superior to, say, a small factory or corner shop of secondary quality. This is a widely diverse market.

 Although strata offices, retail and industrial real estate are under the broad umbrella of small commercial properties, each has its own investment characteristics.

 Quality strata offices are currently the pick of the small commercial properties, but would-be investors should still be cautious with that segment of the market.

 Vanessa Rader, national research director for property consultants and valuers LandMark White, says the best strata offices in the CBD and main non-CBD centres are benefiting from a spill-over effect of the severe shortage of vacant space in the top office towers across Australia.

 As rents rise and available space continues to shrink in the major office buildings, Rader says demand is spilling over to quality strata offices. “The market for prime strata offices is looking pretty good,” she says. But Rader does not expect the spill-over demand to trickle down to poorer-quality strata offices.

 Rod Cornish, head of property research for Maquarie Real Estate, underlines the sheer shortage of all categories of office space, including strata. “The vacancy rates in Perth and Brisbane are the lowest since records began to be collected 30 years ago. Melbourne is at the lowest for 18 years, and Sydney is at the lowest for five years.”

 Rader says vacancy rates for all types of office properties (including strata) in Melbourne, for instance, have hit 4.4% of total office space, and 3.7% in Sydney. A vacancy level of 7% to 9% is considered desirable for the smooth change-over between tenants.

 “A key is that there is not a lot of supply in strata offices becoming available across Australia over the next 12-18 months, and vacancy rates will remain reasonable low,” Rader says.

 There is, however, somewhat of a paradox occurring regarding all types of office space, from the CBD towers to suburban strata offices, that would-be investors should carefully note.

 On one side, high demand and a shortage of space are pushing up rents. But on the other, the global credit squeeze is forcing up interest rates and making finance harder to obtain.

 The bottom-line is that despite the growing rents, higher interest rates will lead to buyers expecting some easing of prices for buildings and strata offices in order to make an adequate return on their investments.

 Cornish expects the reduction in prices to be most pronounced among properties of secondary quality with poorer quality tenants. “Offices [in the top office towers] with prime corporate tenants have secure cash flows,” he says. Any strata offices with less than first-rate tenants could be more vulnerable to their prices being driven down. (An additional factor is that offices of secondary quality are more likely to be affected by any slowing of the economy.)

 But then Cornish points out that the combination of rising rents and possibly falling prices for some offices could open up new investment opportunities. Prices have not yet eased, he says.

 Rader has mixed feelings about small strata factories and warehouses. There has been a glut of these properties but few new ones are being built, and she is confident that their vacancy rates will fall as demand increases. “But industrial strata property may take a long time to reach its potential,” she cautions.

Small investors should perhaps stay away from small shops outside the prime retails areas. Retail spending faces uncertainty with the expected slowing of the economy, falling consumer confidence. Investment yields on retail properties are already very low. You will almost certainly find better property investments elsewhere.

 Here are 10 top tips for staying out of trouble when investing in small strata offices:

 1. Forget gut feelings: Rod Cornish of Macquarie Real Estate warns that while many small investors seem to have an uncanny gut feeling for residential property, this may not transmit to commercial property. (See next tip on research.)

 2. Closely research the market: Rather than just having a gut feeling about a property’s investment potential, obtain quality research of the particular market to help guide your investment decisions. “Research of the commercial property market is not as readily available as with the residential market,” Cornish says. But quality research is definitely undertaken.

 3. Stick to quality properties that will attract quality tenants: Would-be investors should make sure their cash flows are as secure as possible by buying properties that will draw the best-available tenants. (Of course, many SME owners buy strata offices through their DIY super funds and arrange for their own businesses to become the tenants at a commercial rent.)

 4. Treat properties with extraordinary high yields with suspicion: If a strata office’s sale price seems extremely low given the high rents being received, be extremely cautious. This may mean that the existing tenant may be less than secure; not locked in for a long period, slow on rent payments, or experiencing business difficulties. “High yield usually translates to high risk,” Rader says.

 5. Understand that the maintenance costs of commercial properties are higher than residential: As Rader emphasises, strata properties are typically subject to higher rates and taxes, higher insurance, and higher real-estate agency fees. New tenants expect incentives such as rent holidays. And there is usually a longer period between tenants compared to with residential properties. “All of these add up,” says Rader.

 6. Ask yourself what would happen if the investment fails: Small investors who are thinking about investing $500,000-plus on a single investment, probably much of it financed with borrowed money, should think about the effect on their financial well being if it fails. Consider the possible desirability of, alternatively, reducing risks with a widely diversified investment portfolio. (See tip eight about property trusts.)

 7. Question whether this is the right time to borrow heavily: With the combination of the global credit crunch, rising interest rates and the prospect of a slowing economy, many investors believe this is the time to be reducing their borrowings – not increasing them.

 8. Consider investment in property trusts rather than directly in a strata office: With listed and unlisted property trusts, you can gain exposure to a broad  range of quality tenants in quality properties and in a variety of markets.

 With a single directly owned strata office, you are tying yourself to the fate of a single tenant in a single property and to a single location. The level risk with one directly-owned property investment can be markedly higher than through a carefully-selected managed investment.

 Listed property trusts are, of course, highly liquid but are subject to the sometimes extreme volatility of the sharemarket. Given the sharp fall in their share price over recent months, listed property trusts may provide excellent opportunities for highly selective buying.

 9. Look for opportunities: The prevailing credit squeeze and higher interest rates is likely to lead to an easing in prices for office property, including strata offices – despite rising demand and rents for quality space. In turn, this may eventually lead to some good buying opportunities, as discussed earlier in this column.

 10. Think years ahead: Before buying a strata office, keep in mind that you will probably want to sell it on or before your retirement. This may trigger such questions as: How many years do I have before retirement? What happens if market for strata offices is less than favourable at the time of my retirement? Who would be the likely buyers of such a property? This forward thinking is typically encouraged by accountants, business advisers and personal financial advisers.