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tenants) hinders rather than helps the very people that the in- (your!) property all the time, whereas residential tenants do
terference is designed to protect. not really care.
It is incumbent on all of us to be aware of what local and Some of my commercial tenants paint their premises
national politicians are trying to impose, to think it through, every two years, not because they want to please me, but
discuss it, and to do our bit to ensure that the market is kept for their own reasons. More important, if a tap leaks in one
alive, pure, and functional. This is not just self-serving; it also of my commercial properties, the tenant tends to either fix
helps tenants, the very body of people that the government it, or have it fixed by someone fast: They earn their in-
purports to be protecting at our expense. come there and want to get on with the job at hand. With res-
idential properties, on the other hand, even if the tenants
have the skills and tools to make minor repairs, the psychol-
ogy of renting houses is that you call the landlord if anything
happens.
In other words, I get far fewer calls to fix and repair things
on my commercial properties than I do on residential.

Lease Length
Another fundamental difference between residential and com-
mercial property concerns the typical length of the contracted
lease period.
With residential properties, it is slowly becoming more
popular to have six-month contracts or even one-year con-
tracts. But in many places, residential properties are still
rented out on a month-to-month basis.
Commercial properties, on the other hand, are generally
leased out for many years at a time. On smaller strip mall–style
shops, the rental period may only be for periods of two years at
a time. But on larger buildings, the leases may run for many
years—leases of twenty years are not uncommon.
With residential properties, from a tenant’s perspective, a
long lease is seen as an imposition, as something that reduces
your freedom to move on if you so desire. After all, if you pay
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158 REAL ESTATE RICHES GOVERNMENT INTERFERENCE 171

the rent on time, your landlord is unlikely to want to evict you, The net result is the exact opposite of that intended by in-
so why sign up for a long time? troducing the rent-rise restrictions in the first place. The best
With commercial property, on the other hand, a long thing for governments to do when rentals rise steeply is sit
lease is generally seen as something desirable from even the back and do nothing, as then, again through supply and de-
tenant’s perspective—it gives their company or business the mand, developers will build new housing stock until rentals
security of the same premises to operate out of. In fact, many come back down to an equilibrium.
tenants of mine, as their lease draws to an end (or sometimes This phenomenon is real. The Netherlands introduced
years before), ask me for a new, longer lease, or an extension rent-rise restrictions soon after the Second World War. An aunt
on an existing lease. This may sound absurd initially, but of mine in The Hague lived in the same apartment for forty
consider a tenant who wants to sell his business. He will not years because her rent was the equivalent of around $38 a
get much for it if the lease only has seven months to run and month, and the day she moved, she would have had to pay
he cannot guarantee that you as landlord will extend the market rentals somewhere else that would have been orders of
lease for the new tenant. Part of the value of any business is magnitude higher. Since rentals were kept artificially low by
the goodwill factor of clients knowing where the business the rent-rise restrictions, yields were artificially low, and there-
is, and going there regularly. To be sure to maintain that fore developers had no incentive to build new stock. Is it any
goodwill, many tenants will seek out long-term leases. Banks wonder that the Netherlands had a housing shortage long after
obviously like long-term leases as well: The longer and Germany did, even though a much greater proportion of Ger-
stronger the lease, the more willing they are to lend money many’s housing stock had to be replaced?
on the property. In New Zealand in the mid-1970s, the flamboyant prime
minister at the time, the late Sir Robert Muldoon, introduced
not just a rent restriction, but a rent (and wages) freeze. The net
effect was a chronic shortage of rental accommodation, and
Getting a New Tenant prices that, when the rent freeze was finally and inevitably
With residential property, if a tenant leaves, that is usually the lifted, went sky-high.
end of your association with that tenant. Certainly, if a new In the United States, the city with some of the highest
tenant fails to pay the rent, you cannot go back to the previous rentals in the country, San Francisco, is also the city with the
one and ask him for the shortfall! And yet that can happen with harshest rent-rise restrictions.
commercial property. My point in raising this whole issue is as follows. The rea-
When a business is sold, it is not as if the existing lease son why property works so well as an investment vehicle all
comes to an end, to be replaced with a new one for the new over the world is largely because it is self-directed and self-
tenant. Rather, an assignment of lease document is exe- regulated through the natural forces of supply and demand.
cuted, which means that the lease is assigned or transferred The minimal government interference that there is (through
to the new tenant. Clauses in this document stipulate that rent-rise restrictions and absurd and onerous obligations im-
should the new tenant fail to meet its obligations, then the posed on landlords to be forgiving of defaulting residential
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170 REAL ESTATE RICHES RESIDENTIAL VERSUS COMMERCIAL PROPERTY 159

protect innocent tenants from the greedy claws of rapacious previous tenant is still there as guarantor to the new tenant.
landlords. Part of the reason for this is to prevent a tenant who wants to
On the surface such restrictions sound perfectly justifiable. quit his business from selling it to anyone at random and
Assume that for whatever reason, there is a sudden shortage of thereby absolving himself of any lease responsibilities. With-
accommodation, and that landlords capitalize on the situation out such a clause, few landlords would ever sanction the sale
by increasing the rent on their properties to way above what of a business. Of course when the lease comes up for re-
the market “should be.” Tales of suffering of particular tenants newal, then only the incumbent tenant will sign (the previ-
are reported on the news, and before you know it, politicians ous tenants are not required to stay on the new lease, and
are on their soapboxes promoting the imposition of rental would be foolish to do so).
controls so that landlords cannot increase their rentals “on a Sometimes, a business operated in one of my properties
whim.” Needless to say, the theory is well received, as which may have had three or four assignments of lease during the
good citizen with a conscience would want these tenants to term of the lease. I do not mind at all: I then have three safety
suffer at the hands of the rapacious landlords? nets to ensure that the rent will be paid.
A law is passed, limiting the increase in rent that a landlord
may impose to the annual inflation rate, or to the consumer
price index. So far so good.
But before long there is a problem. Sometimes, property
Finding a New Tenant
values (and therefore rental levels) rise more slowly than the So far there have been a lot of advantages of commercial prop-
general inflation rate, and sometimes they rise faster. Let’s as- erties. Not all the advantages are stacked in the favor of com-
sume that property prices have doubled in a relatively short mercial property, though.
time (because of the same forces of supply and demand that The biggest advantage of residential property over com-
would have caused rents to rise), but that rentals, restricted to mercial comes when your property is empty. If you have a
the inflation rate, have only gone up by 5 percent. Suddenly, house where the tenants have just left, then it should be rela-
the yields on rental properties have almost halved. The natural tively easy to find new tenants. If it has been empty for three
effect is that fewer investors will want to invest in property in weeks and you are starting to despair, then do not fret! The
that region, and many existing investors will sell and get out. house is not empty because the carpet in the living room is the
Consequently, the pool of available rental stock will diminish. wrong color, or because the bedroom is facing the wrong way,
Through the forces of supply and demand, the price of rental or because the window in the dining room is too high. There is
accommodation would be driven up even further, but because only one reason why the house is still empty: The rental is too
of the rent-rise restrictions, the few available are held artifi- high relative to market rental in that area at that particular
cially cheap. A black market may develop, people become re- time. Drop the rent by 5 percent or maybe 10 percent and you
luctant to move (because then landlords can impose a new, will get a tenant.
“market” rental), and the spiral continues. With more investors On the other hand, if you have a commercial property that
leaving the market, rental prices rise even further. has been empty for three months or even three years, then the
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160 REAL ESTATE RICHES

problem may not be that the rent is too high. Even if you were
to slash it in half or more, you may still not find a tenant.
The reason for this difference is simple. Just about any resi- Chapter 15
dential property on the market has all that is required for some-
one to live in it. It will have at least one bedroom, a kitchen, a
bathroom, and so on. In other words, we all tend to agree on
what is needed in a residential property to make it functional as a
home, and therefore anyone could, if needed, live there. How-
GOVERNMENT
ever, when it comes to commercial property, how do we stipulate
what is required? The requirements vary wildly from commercial INTERFERENCE
tenant to tenant. Hence, when a tomato cannery becomes va-
cant, it may not simply be a matter of reducing the rent to find a
tenant. No matter how much you drop the rent, no photographer
looking for a studio is likely to settle for the tomato cannery. No

I
t will come as a surprise to many people that the property
wine bar operator is likely to want a mini-storage facility, and no market is in fact the largest industry in just about every
shoe store that largely relies on passing foot traffic will want the Western nation. When you consider the capital tied up in
top floor in an office tower, no matter how good the view or property, and the annual rental values, then the size of the
cheap the rent. property industry exceeds the next biggest industry by a
Commercial property is far more specialized than residen- wide margin.
tial, and hence it may be more difficult to find a tenant in the The fact that the property market works so efficiently is a
areas of specialization catered to by your premises. testament to the natural forces of supply and demand largely
unfettered by the interference of governments. I believe that
property markets are the biggest and most free markets any-
Capital Required to Buy where in the world. Other markets, such as those for com-
modities, stocks, futures, and options, are highly regulated and
There is a general notion that in order to buy a commercial controlled. Real estate on the other hand is mostly left to the
property, you have to be a very wealthy person, while more natural forces of supply and demand.
modest means will suffice to buy a residential property. While There are some notable exceptions, however, that make an
in general this may be true, we have already seen in Chapter 8 interesting exercise in showing how, more often than not, the
that it is possible to buy a viable commercial property for effect of government intervention is exactly the direct opposite
$59,000 that has all the advantages of any commercial prop- of that intended.
erty. So long as people think that commercial properties are ex- Let me give you an example. At various times, governments
pensive, then you will have little competition looking at small have deemed it necessary to impose rent-rise restrictions to
(low capital value) commercial buildings.

169
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168 REAL ESTATE RICHES RESIDENTIAL VERSUS COMMERCIAL PROPERTY 161

have signed up on long-term leases, you as landlord have To the extent that it is true that commercial properties are
stronger remedies if the rent is not paid, and since the tenants generally more expensive than residential properties, there is a
derive their income there, the chances of having defaulting commensurate benefit. To own $10 million worth of residential
tenants is in my experience much less. property, you generally would have to own a lot of separate
The reasons I have just outlined may help explain why, of properties, with many dozens of separate rental agreements.
all the extremely high-net-worth property investors I know, The management overheads could be huge! A single commer-
only two own predominantly residential properties. The rest all cial property, on the other hand, could be worth the same $10
own commercial. million. You may have only one lease document, and therefore
much reduced management concerns.
Since there are so many people in the market for a
residential property, and since the capital values involved
tend to be much smaller, it will be much more difficult to
find a residential property selling for less than 10 percent of
its replacement cost than a commercial property at such a
discount.
Let me give you an example. In the mid-1990s I was in-
volved in a bid on a building in downtown Dallas, Texas,
known as the Republic Tower. It actually comprised three tow-
ers of fifty floors, thirty-three floors, and eight floors respec-
tively. When the first tower was built, it was the tallest building
west of the Mississippi. The revolving searchlight on top could
be seen at night for many miles. The buildings comprised a
massive 1.92 million square feet of rentable space. The cost to
replace the buildings was around $300 million. What would
you have offered for these buildings?
My consortium’s offer was in fact for $15 million. That is
not a typo! We were offering around 5 percent of the cost of re-
placing the buildings.
Now at this stage I should give you a few more details.
Commercial buildings are generally valued on the basis of their
rental income. The Republic Tower back then was only around
6 percent leased. In fact, the total rental income did not cover
the operating expenses: There was a shortfall of $1.6 million.
Based on a capitalization rate of around 10 percent for office
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162 REAL ESTATE RICHES RESIDENTIAL VERSUS COMMERCIAL PROPERTY 167

space, that would have put a value on the property of negative

$16 million.
Residential or Commercial—
On the other hand, with market rentals of around $20 Which Is Right for You?
per square foot (per annum), the building had a potential
Whether you should invest in residential property or com-
rental income of nearly $40 million per year (1.92 million
mercial property is a decision that you will have to make on
square feet times $20 per square foot). At that same capital-
your own. I do have some points to offer for your considera-
ization rate of 10 percent, that would give it a value of almost
tion, though.
$400 million.
If real estate seems daunting to a lot of people starting out
Now for a number of reasons, our bid was not successful.
in the game, then commercial property is far more daunting
In case you are thinking: “I should think not! I don’t want to
than residential. The reason is simply that everyone knows
hear of anyone buying well over $300 million worth of prop-
what constitutes a home that someone could live in. You would
erty for $15 million in one fell swoop,” then take heart. In De-
notice the absence of a kitchen, or a bathroom, or if there were
cember of 1997, the property was reportedly sold to a
no windows!
partnership involving Credit Suisse First Boston for the
However, if you came across a commercial property with
princely sum of $25 million. They are now spending $75 mil-
no kitchen, no bathroom, or no windows, would that matter?
lion completely refurbishing the property (including, for in-
Storage units would be worth less if they had windows (as then
stance, replacing all of the 8,000 panes of glass with
people could see what you were storing, and the risk of theft or
dual-pane, energy-efficient reflective glass). But even so, it is
arson would be greater). So it is much more difficult for begin-
a great deal, and a testament to my strategy that you can find
ners to know what it is that commercial tenants will want.
properties that are selling for a fraction of their real value, if
Whereas residential properties tend to have a lot in common,
only you are willing to look for the extraordinary, for proper-
commercial properties are far more specialized.
ties with a twist, for properties where by changing something
Having said that, if you are serious about having a growing
around, you can reap huge benefits.
portfolio, then for me I would rather have a large amount of
Another deal I was involved with concerned a massive single-
money tied up in commercial property than in residential
story building in the Sydney suburb of Yennora. Known as the
property. Imagine if you wanted $20 million worth of proper-
Sydney Wool Exchange, this building comprised a vast three
ties. That would be a lot of homes, with a lot of plumbing,
million square feet of warehouse space. It was believed to be
roofs, gardens, and wiring to maintain! On the other hand, a
the largest building in the Southern Hemisphere, and it took
commercial portfolio of $20 million may comprise just a few
quite some time just to drive around the perimeter. The wool
properties, with much less management overhead. Further-
clipped from some 20 million Australian sheep would pass
more, the tenants of commercial properties tend to pay the
through its storage facilities. The building was built for the gov-
outgoings (property taxes, insurance, maintenance, and so
ernment, owned by the government, and leased to the govern-
on), they have a vested interest in keeping the properties look-
ment. And now, the government had decided it was time to sell.
ing good, there is much less government interference, they
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166 REAL ESTATE RICHES RESIDENTIAL VERSUS COMMERCIAL PROPERTY 163

Residential Versus Commercial Property Since the rental income was $7.9 million, and since capital-
Residential Commercial
ization rates were around 11 percent, it was determined
through initial negotiations that a sale might be effected at
Rentals are quoted monthly or Rentals are quoted annually. around $72 million.
weekly.
On the face of it, a return of 11 percent would not get
Tenants have little interest in Tenants have a strong vested me excited at all. However, there were some extenuating
maintaining or improving the interest in keeping the property circumstances.
property. looking good and functional, First, by only considering the capitalized income, you are
and even improving it. completely overlooking the fact that the three-million-
Leases are nonexistent or tend to Leases tend to be long. square-foot building was sitting on seven million square feet
be short. of land. The government had not taken the land value into
account, probably on the basis that it was not generating any
Tenants phone you for minor Tenants tend to fix minor
income anyway. The surplus land was worth some $16 mil-
problems. problems.
lion, however.
Bureaucrats tend to stick their Bureaucrats tend to leave you Second and far more important, the government, as we
noses in protecting the rights alone. have noted, was leasing this building to themselves. In other
of the tenant.
words it was money out of one pocket and into another. They
Capital required to buy can be Capital required to buy can be had no vested interest in getting a market rental for the build-
minimal. large. ing, as it would not benefit them anyway. The average rental of
some $2.63 per square foot was nowhere near market rentals.
Banks will easily lend up to 90 Banks will lend only 50 percent
percent and more of appraisal. to 60 percent of appraisal. The large, national tenant in the building next door was paying
$5.60 per square foot, more than double.
Appraised value when empty is Appraised value when tenanted We commissioned an appraisal, which came in at over $140
not much less than when may be two or three times the million. In the end, we were outbid by a consortium from Hong
tenanted. value when empty.
Kong, who bid $2 million more than we did, but they still got it
If the property is empty, it is usually If the property is empty, it may at effectively half price. The point is, these deals exist! In this
easy to find a new tenant. be difficult to find a new case there was over $60 million to be made after costs.
tenant. In mentioning these examples, I am not trying to impress
For a large sum invested, the For a large sum invested, the you with big numbers, but rather trying to impress upon you
management overhead can be management overhead is that great deals happen all the time, from little $22,500 cot-
high. usually low. tages and $59,000 commercial buildings, right through to com-
mercial properties worth many hundreds of millions of dollars.
You deal with people. You deal with contracts.
And by the way, the effort involved in buying a $1 million
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164 REAL ESTATE RICHES RESIDENTIAL VERSUS COMMERCIAL PROPERTY 165

building is about the same as the effort involved in buying a easier to do with commercial properties than with residential
$100 million building. Would you rather do a $100 million deal properties.
once, or a $1 million deal 100 times?

Management Overheads
Loan-Value Ratios Available The nature of residential properties is such that once you get to
Banks and financial institutions will easily lend you 80 percent own about twenty of them, you almost have a full-time job
of the value of a home. Some readily go to 90 percent, and de- looking after them. Of course weeks may go by where you have
pending on economic circumstances, some even go to 100 hardly any phone calls, late rent payments, or maintenance re-
percent and above. quirements to sort out. By the same token, during some weeks
Such high loan-value ratios, however, are extremely un- you may be working overtime.
common with commercial properties. Typically, banks will Commercial properties on the other hand are not nearly
lend 50 percent of the appraised value of a commercial prop- as demanding of your time. As we have seen, tenants tend
erty. Some will go to 60 percent, and more rarely you can talk to look after minor repairs themselves. Tenant turnover is
banks into 66 percent. not nearly as high, and is very predictable—just look on
Having said that, it is generally much easier to instantly in- your lease schedule to see when the leases come up for re-
crease the value of a commercial property from the low pur- newal. When you have many tenants in one building, one
chase price you paid to the new appraised value after you have watertight roof means many tenancies with no leaking roof
owned the property for a few weeks. The reason is simply that problems (compare that with residential properties, where
an empty residential property still appraises for close to what twenty tenants in separate homes means twenty roofs to
its value would be if it were occupied. However, an empty com- maintain).
mercial building is not worth much at all. The difference in management overheads can be high-
Consequently, you may buy a commercial property for a lighted in another way: Whereas all of my residential proper-
song, put in a tenant that you had lined up before you bought ties are managed by professional managers, many of my
the property, get a new appraisal, go to a bank, get a modest commercial properties are not managed by outsiders at all.
50 percent mortgage, and still end up with more money than These properties attract so few phone calls per year, have so
you need to pay for the property according to the contract few maintenance and upkeep requirements, and have such
price. I did a similar thing with the funeral parlor described low tenant turnover, that it does not seem cost effective to me
earlier. You may recall I bought it for $170,000. That is proba- to give up 10 percent or even 5 percent of the rent roll to have
bly all that it was worth empty. However, with tenants in- someone else handle the few calls and management issues
stalled paying $30,500 per annum, even the bank thought it during the year.
was worth at least $240,000. My 66 percent mortgage of Here is a summary of the differences between residential
$160,000 almost covered the purchase price. These things are and commercial property.