Is ‘By the slice’ Pizza the next revolution in commercial real estate investment?

Long before Domino’s and Pizza Hut existed in Mumbai there was a pizza chain called Smokin’ Joe’s. It served pizzas that were amongst the best in the late 90’s and early part of the millennium. Pizzas were considered exotic then and since they were large, the price was outside my budget to be able to afford it regularly. I recall wishing – “If only they would serve pizza ‘by the slice’ instead of the regular 10-inch or 12-inch – then I would be able to have it more often.”

In commercial real estate something similar has existed for long. Unlike the residential market where rental yields are terribly low – in the commercial market the yields are honorable at 7%-8%. The only problem was accessibility to that asset class was restricted to only a handful of participants. One primary barrier was the ticket size of a high-quality commercial space. In the last few years an option has emerged called fractional ownership. Fractional ownership is akin to selling a single commercial asset ‘by the slice’ to numerous investors. Simply put, if an office space is a 12-inch pizza with eight slices, each slice can be sold to eight different investors.

The minimum investment required is INR 25 lakhs in most of the platforms although the threshold has been lowered by select platforms to even INR 5 lakhs. Two parameters that are non-negotiable in this product are 1) Only ready commercial property and no under-construction 2) Existing tenant already occupying the space so the rent flows to the new buyers/investors immediately.

There are two sources of returns for investors in this: 1) Rental income 2) Capital appreciation IF the property is later sold at a profit.

The broad process is straight-forward: Step 1: Fractional ownership platforms identify a particular asset that is considered lucrative. Step 2: Through a mechanism of quasi crowd-funding they raise capital to purchase the asset. A company is created to purchase the asset. Step 3: After the requisite capital is collected, the asset is purchased with multiple investors being stakeholders in the company. Step 4: The tenant starts paying rent to the company – which thereafter distributes to investors. Step 5: After a certain duration the asset is sold and investors get their investment back – at a profit or loss.

In the last two years several companies are offering fractional ownership services with their own niche. Strata has a focus on warehousing assets. MYRE Capital is targeting Grade A assets in key markets. hBits appears to be aggressive in penetrating the market. Several others exist which are trying to attract investors.

Personally, I am delighted to see new opportunities emerge in real estate investment. Entrepreneurs with diverse backgrounds are making a move in this segment from – lawyers, investment professionals, architects, brokers etc. I have often been asked by potential investors regarding the best platform to make their investment. My answer is simple: Don’t look at the platform. Focus on the asset on offer. (Do however note the fees each platform charges investors)

Here is the approach I would recommend investors when identifying a particular asset:

1)      Asset quality: The most important factor is to consider assets that are perceived as Grade A. The price is on the higher side and it is rarely available at distressed valuations. But that is its inherent strength. Its demand holds up even in adverse circumstances. Often these are buildings where the developer still owns some units. With that in mind, it’s a bit alarming to see select platforms today offer investors almost Grade C opportunities, but label them as Grade A assets.

2)      Tenant: In my view the second critical factor is to note the quality of tenant that is occupying the Grade A space. The tenant should be financially strong and credible to ensure timely, consistent and stable rent payments. MNC’s or large Indian corporates should be the preferred bets as they normally invest well in fit-outs thereby creating a disincentive to vacate the property. There are cases already wherein a Tier 2/3 tenant has vacated the property and it is lying vacant for almost a year with investors receiving no rent.

3)      Micro-market: Focus on the micro-market where there is low vacancy and there is not significant upcoming supply. That will ensure rentals don’t come under pressure. And an exit is easier given the limited number of options. Remember, given the nascent nature of the business, there is no serious track record of properties having an exit (sale) and investors then receiving back their investment.

4)      Lock-in period, rental yield: There is a temptation to have this as the top parameter. Lock-in period ensures revenue visibility until that duration. Higher rental yield means a higher rental payout in relation to the value of the property. For me, a weak tenant in a Grade B or C building negates a longer lock-in period and higher rental yield.

5)      Price: If one buys at a good price then the possibility of exiting with capital appreciation is higher. It is imperative for investors to independently assess the pricing of the asset, as every platform will market the property as a lucrative one. It is a bit disconcerting to gather that the pricing of some assets is being discussed at a meaningfully higher price to similar units in the same building. It may be old-fashioned corruption at work or it may just be easy capital driving up prices.

Over and above all this – it is critical to remember that currently fractional ownership is not under any specific regulation. It will happen eventually. But in the interim if something adverse were to happen – it is likely that each investor would be on their own.

With this backdrop fractional ownership will not create a revolution in commercial real estate investment. But it has promise, just check the toppings before eating the slice.

(Source: Moneycontrol)

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