In a real estate environment of diminishing returns, like the one we’re experiencing in the GTA, it’s important that investors seek opportunities to diversify their portfolios. A reliably profitable way to achieve that diversification is through commercial investment.
The commercial real estate market is short on supply and long on demand, especially in niche pockets with unique product offerings that are hard to replicate. Residential densification is being encouraged to accommodate a growing population, which has resulted in increased demand for commercial space in landlocked business parks.
Choosing commercial real estate over residential provides several advantages. Commercial leases fall under contract law and therefore protect the landlord. There are no limits on rent increases. In addition to rent, tenants pay for taxes, maintenance and insurance. Tenants also pay for improvements to the space, which are often left behind to the benefit of the landlord. And if a tenant fails to pay what they owe after 15 days, it is lawful for the landlord to enter and repossess the premises. Try doing that with your basement suite.
Commercial’s current climate
Office and industrial sectors provide the best prospects in commercial real estate, both today and going forward, with current cap rates of 5% to 6%, strong demand, historically low vacancy rates, strained supply, and limited product in the pipeline. This creates a perfect storm for rent and price increases. Retail might be experiencing immense pressure, with the growth of online shopping forcing large chains to close their doors, but the industrial sector is prospering from this trend, with runaway demand for warehouse and fulfillment space from online retailers and e-commerce.
Industrial land transactions are at the lowest level since 1998 due to a restricted geographic ability to expand, which is in turn pushing prices up. At the time of writing, there were only 35 industrial units up to 1,500 square feet for sale or lease on the MLS in all of York Region and Toronto. Prices have risen steadily year over year and will continue to do so until supply increases or property becomes too expensive.
The industrial property availability rate (the amount of space available divided by the total inventory of space) in the GTA is currently 1.5%, and the vacancy rate is 0.4%. Both are all-time lows. The historic average availability rate is 5%. Based on these numbers, even if demand for space were zero, it would still take approximately five years to create enough space to return to the average, based on the current annual supply of 5.3 million square feet.
What to look for
To get started in commercial real estate, I suggest smaller industrial units of around 1,000 square feet. These can be purchased right now for approximately $250 to $300 per square foot with frontage/exposure to high-traffic roads in key locations. (Interior industrial units in the same buildings that lack this exposure can be picked up for around $200 to $250 per square foot.) Consider investing in several smaller units instead of one larger one.
Look for spaces with high-traffic exposure that allow for up to 80% to 100% office use. That kind of space will appeal to a wide variety of users, such as doctors, dentists and other highly paid professionals. Since office space commands a higher rent per square foot over industrial, office users will see lower rents and the potential for better exposure in industrial space.
Zoning and location are other key factors. A designation that appeals to a wide variety of uses is always more valuable. Ideal locations include those near major highways or public transit, with a loading dock and at least one drive-in dock that has 53’ trailer access. It should be freehold if possible. Clear height is also becoming increasingly important to tenants. Restricted industrial land supply users, especially e-commerce and fulfillment, will be looking to take advantage of vertical space.
An sample investment
Let’s take a look at the example of an 1,000-square-foot industrial space in Aurora, a key location with frontage/exposure on a high traffic road that can be used as office space.
With 30% down, this type of purchase would cash flow in the first year. These numbers can be scaled accordingly, from individual units to entire buildings.
After five years, this is a sustainable investment with increasing cash flow and strong fundamentals for capital appreciation. And historically, a 50% debt-to-equity ratio can weather the worst economic events.
Industrial property supply will continue to be constrained while outpaced demand persists, leading to increases in both rent and prices. The economy is strong, interest rates are low, and the unemployment rate is at 5.5%, a low not seen since the 1970s. Now is a great time to own commercial real estate.