Is it worthwhile to invest in Commercial real estate as compared to Residential Real Estate in India?

Author: Sachin Gupta | Find me on Twitter Follow @sach_gupta
 

People invest their money to achieve targeted rate of returns. Returns vary depending on the investment asset class such as stocks, gold, real estate, mutual funds, fixed deposits, etc. However, in India, majority of people invest their savings primarily into real estate and gold. There are two reasons for it, one – financial markets are complicated to understand and second – they invest in real estate and gold to hedge against inflation (knowingly or unknowingly).

Within real estate, there are various asset classes such as commercial office space, retail spaces, residential, warehouse, institutional, etc. However, about 80% of investment in real estate goes to residential asset class owning to its safe nature and demand from rising middle class.

However commercial real estate or income properties can yield better returns provided one has sufficient knowledge of the city, its expansion plans, industry base, and income levels of the people living in the city. The investor must consider many variables when acquiring income properties:

1. Market Factors (Demand & Supply)
2. Occupancy Rates
3. Tax influences
4. Level of risk
5. Amount of debt financing
6. Proper framework to measure return on investment

Motivations for investment:

1. Rental income
2. Capital appreciation
3. Portfolio diversification
4. Tax benefits

Understand before investing:

Because of highly competitive nature of the industry and its difficulty in forecasting demand, there are certain times when excess supply is unintentionally produced, thereby increasing vacancy rates, reducing rents, and causing volatility in property values. As an example, even though there may be a definite need for additional Office Space in Gurgaon, the potential for over-development will exist as each developer rushes to deliver additional space to the market before competitors. This phenomenon creates a cyclical pattern in real estate industry.

For example, if the demand for particular property type is less and supply is in excess, then occupancy level and rents will be lower. However, as the demand picks up, the property type will start recovering and occupancy levels and rents will move up.

On the contrary, if demand for particular property type is more and supply is less, then occupancy level and rents will be higher. However, as more space is developed, the property type will come into the balanced stage and occupancy level and rents will come down to optimum/normal stage.

The idea is to understand, what the demand for particular property type is and how much space is already available. As an example, the demand for IT Office Space in Gurgaon is high; however we need to measure the current available space and future developments.

Investment analysis:

In general, when we refer to investment analysis in real estate we are referring to analyzing a particular property to evaluate its investment potential. This analysis should also help answer other important questions: 

1. Should the property be purchased? 
2. How long should it be held? 
3. How should it be financed? 
4. What are the tax implications of owning the investment? 
5. How risky is the investment? 
6. Two key terms: Internal rate of return (IRR), Present value should be calculated

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