Have you seen the new legislation released by the government? Are you considering buying, selling, or building a commercial building?
Understanding the current market value helps you decide if it is worth starting a commercial building project. It also allows you to calculate the estimated margin or capital gain between the construction cost and the potential sale price.
In this article, we outline the various drivers of the commercial property market and explore the role of CAP rates and rental rates. We also explore how the government’s policy on depreciation has impacted building tax over the past several years.
Please note that the below information is generalised - please seek the advice of a suitably qualified professional to give advice relevant to your circumstances and the current regulations.
Building Depreciation NZ
In recent years, New Zealand has seen major policy changes surrounding commercial building depreciation. From 2012 to 2020, the depreciation rate for most buildings was set at 0%.
However, on the 25th of March 2020, depreciation was reintroduced for non-residential buildings with a 2% diminishing value or 1.5% straight line. This meant building owners could claim depreciation on their commercial buildings and receive an adjusted tax value, reducing the tax they needed to pay.
In April 2024, most commercial building depreciation was changed back to 0%, affecting all non-residential buildings with an estimated useful life of 50 years or more.
Technically, buildings are still considered depreciable property but the annual depreciation rate is set at 0%. This ensures properties are still subject to certain depreciation rules, such as depreciation recovery income if a building is sold for more than tax book value.
If the building you own has an estimated useful life of less than 50 years according to IR265 General Depreciation Rates, you can claim depreciation deductions as you did before.
How to claim depreciation
If you own a non-residential building, you can claim depreciation deductions using one of two methods — the straight-line (SL) method or diminishing value (DV) method.
The Diminishing value method (DV) is calculated annually, using a constant percentage of the asset's adjusted tax value. This means your depreciation deduction will progressively reduce each year. In the
Straight Line method (SL), the asset’s value depreciates each year by the same amount, based on a set percentage of its original cost price.
Once you've decided on the method, you’ll have to identify the correct depreciation rate depending on the date you acquired the asset. For all depreciable assets acquired after 1 April 1993, you can use the IRD depreciation rate finder or find the rate here, via the relevant industry and asset. However, when the rate is 0%, there will be no deduction available.
What drives the commercial property market?
Commercial property is an investor-driven market, which means almost all properties are owned by investors. Generally, even owner-occupied properties are owned as an 'investment’ that is leased back to the owners or the business. This is in contrast to the residential property market, where there is a large owner-occupied market and many more emotional factors at play.
What is a CAP rate?
The dominant factor in the commercial market is the rate of return, commonly known as the Capitalisation rate or CAP rate. This is the total rental value, as a percentage of the property's value.
For example, if you have a $1,000,000 property and the rent is $60,000p/a, this is a 6% CAP rate. If you reverse this, it can be used to calculate the value of a property. For example, if you pay $100,000 in rent per annum, the property investors would look for a 6% CAP rate. This means they would be willing to pay $100,000 / 6% = $1,666,667.
The question is — if you have not built or bought a building, what is a realistic rental rate or CAP rate?
What is an expected CAP rate?
Investors in main centres are typically looking for a 5-7% CAP rate. In the regions, this can be higher, with some investors looking for a 10% CAP rate before starting a custom build. If you're looking to sell or build and sell to an investor, an attractive property with a lower CAP rate allows you to sell for more with a market lease rate. So what impacts the CAP rate?
Quality of the tenant
Banks and investors want to know how strongly the tenant will occupy the building. Generally, national chains are regarded as strong tenants because they don't move around much and are often on longer leases of 10+ years. They are also regarded as more financially stable when compared to a smaller business which may not have an established nationwide trading history.
However, that is not to say that a local business would be discounted if they are clearly a well-established and stable entity.
Length of the lease
Longer leases are more attractive to investors so are more likely to accept a lower CAP rate. For example, a 10-year term may tempt an investor to accept a lower CAP rate as they will have stable returns. On the other hand, a 3-year lease may not be as appealing, as they run more risk of having an untenanted property.
The prospect of rent increases
If a property is leased below market rate, a savvy investor may be happy with a lower CAP rate as they can see the ability to increase lease rates. For example, they might be able to increase the rates for the existing tenant or find a higher-paying tenant to increase their return.
What is a rental rate?
Most businesses look at rental costs on a cost per m2 basis, generally broken into rates for warehouses, canopy offices, and yard areas. The rate varies, depending on location and the building spec. For example, high-bay warehousing commands a higher rental value than a low-stud workshop and a higher-spec office would command higher rates than a simple one.
Local real estate agents are generally well acquainted with rental rates and local nuances. For example, a certain type of warehouse or office may be scarce in an area, commanding a higher premium. On the other hand, another building design might have expensive features that are not valued by the local market, which may prove to be a poor investment.
Colliers regularly provide averages for rates on their website, as shown in the below snippet.
Source: Colliers
What impacts commercial property value?
If you are buying or selling an existing older building, the cost of any remediation work to get it tenanted will be a factor. For example:
Is there significant deferred maintenance to be done (e.g. a re-roof or refurbishment of the offices)?
Does the building need to be strengthened to bring it up to new building standards?
What is the title structure, is it leasehold or freehold?
Are there further development opportunities?
Does the building comply with health and safety standards?
If you are doing a new build or ‘spec build’, certain features (like workshop heating) may command a more favourable lease. For example, increasing the height of a larger warehouse may not cost exponentially more but can increase the rent value.
If you wish to discuss your project with our team, please don’t hesitate to contact us directly. We would love to explore your options and advise your best next steps.
