How does the risk of an older property turn into a return?

In the previous article we concluded that, when buying older commercial premises, two things are decisive: does the price compensate for the risk, and can the owner fill the vacant space. Filling space is not solved by price. What matters is location, local demand and the owner's own work: a tenant network, willingness to adapt premises to tenants' needs and active leasing. In addition, the owner must make use of the opportunities of digitalisation. Otherwise time will pass them by. This applies to new premises and prime properties as well.

Value rises from two directions

The market has split in two. Weaker space is the first to stand empty, so the buyer of an older property must know how to fill it. When this succeeds, the risk becomes an opportunity from which the seller eventually makes their profit. This is the core of value growth.

The value of a property is usually calculated by dividing annual net operating income by the required yield. Filling vacant space raises value from two directions. First, net income grows. Second, risk falls, so investors accept a lower required yield.

A worked example with invented figures illustrates the point. A half-empty property yields 200,000 euros a year. Because of the risk, the buyer requires a nine per cent yield, so the price is about 2.2 million euros. Once the space is filled, net income is 350,000 euros. For a stable property a seven per cent yield is enough for an investor, so the value is five million euros. Renovation and leasing cost, for example, one million euros. The owner is therefore left with a value increase of about 1.8 million euros.

The seller receives a price for a fully let, stable property in which the risk no longer exists. The next buyer pays for certainty. Their return is lower but more stable.

Risk is managed in three stages

Risk does not turn into opportunity by itself. The change takes work in three stages.

Before the purchase the risk is priced and contained. The buyer asks local companies and letting agents what kind of premises are in demand and at what price. Where possible, the first tenants are agreed in advance with letters of intent. The condition of the property is surveyed before price negotiations. The repair backlog is deducted from the price so that it does not come as a surprise. The calculation includes a buffer for vacancy lasting longer than estimated, repairs costing more or interest rates rising. The deal must be profitable even then.

During ownership renovations are tied to leases. Premises are adapted to a tenant's needs only once the tenant has committed. In return for the alterations, a long lease is signed. Tenants are sought from different industries so that one leaving does not bring down the entire return. Before signing, the tenant's ability to pay is checked and a security deposit is taken. Occupancy, rental income and costs are compared with the budget every month, so any deviation is noticed in time.

Finally the removal of risk is verified with figures that have already materialised. The financial occupancy rate shows how much of the full rental income is actually realised. The average remaining lease term shows how long the income is secured. Net income is shown as realised over at least one year, because a forecast does not yet prove anything. In addition, an authorised property valuer (AKA) values the property on the basis of signed leases and rents paid. This is exactly the material the next buyer wants to see.

The same data verifies and sells

Leases, rents paid and the valuer's appraisal are ultimately data. When leases are kept in a single register and rent payments are recorded automatically, the owner sees the situation every day rather than only at the year-end closing. The condition of the property and its repair needs are recorded in a condition assessment and a long-term maintenance plan. Remote monitoring continuously tracks, for example, temperature, humidity and energy consumption. Deviations are noticed in time rather than only once damage has occurred. The financier, the valuer and the buyer see the same material at the same time. Technology does not eliminate risk. It makes the removal of risk visible and verifiable.

The same data can also be used in marketing. The real estate sector still does little of this, which leaves room to stand out. In an older property, tenants are often concerned about indoor air. Indoor air measurements are more convincing than a promise of healthy premises. An empty room does not sell. An image of how the space would look in the tenant's own use does. Open data shows which local companies are growing. They can be offered space before their current premises become too small.

Ultimately, the same material also serves the seller. The next buyer wants to see that the risk has gone. A report shows this periodically and after the fact. The advantage goes to the owner whose figures are up to date and ready the moment a tenant or buyer asks.