Lessons in buying property from ‘black gold’

A coffee connoisseur can challenge even an experienced barista. When ordering, body type (skinny/not), marital status (solo or not), length (short/tall), colour (black/white), humidity (wet/dry) and even the angle to the perpendicular (flat or not) are specified.Knowledge Factory recently explored commercial real-estate against the backdrop of the economics behind this revered bean-juice.

Coffee or ‘Black Gold’ is the second-most traded world commodity after oil. It is generally traded in financial instruments known as futures contracts, through the New York Board of Trade. A futures contract is a contract, to buy or sell an underlying instrument at a certain date in the future, at a specified price. For coffee, each futures contract involves the control of 37,500 pounds (±17 tons or 250 sacks) of green coffee – enough to fill a typical shipping container. It is not a small market. Coffee exports alone will account for about $21bn in trade for 2012.

The contract pricing is driven by variables like weather conditions in the producing countries, political turmoil, production levels, transportation costs (linked back to oil) and other unexpected factors. The ‘unexpected’ could be news of drought or freezing conditions in areas of high coffee production which may reduce global supply. Assuming demand stays the same, the decreased supply would drive prices upwards in order to achieve a market-clearing price.

Similar forethought needs to be applied when purchasing commercial property. Many buyers make the assumption that the purchase of well-built office block or factory complex today automatically means solid rental income from the get-go and a handsome re-sale profit in 'five or ten years’ time. In a similar vein to the ‘unexpected’ variables in coffee economics, this is not always true.

Place, time and cycle

If the heterogeneous fickleness associated with the financial aspect of commercial property management is excluded, one is left with an elegant three-point simplicity. These three - geographic, temporal and cyclical elements - ultimately determine when a profit will be made or indeed whether the potential for handsome return on investment (ROI) exists at all.

The geographic element or ‘location rule’ is an ethereal principal in real-estate that can produce high returns when a discounted property is procured in an area of high demand. Alternatively heavy losses can be inflicted when the rule is ignored or where over-capitalisation occurs. Nonetheless, the location principal is constantly shifting. A property in demand today may be out of favour in five years’ time due to changes in business patterns, traffic nodes, a fall in foreign direct investment, politics, a slack economy or decentralisation.

Temporal analysis of a commercial property includes checking the length of anchor tenant leases, and/or surrounding business ventures and business type. For example, buying a factory building in close proximity to a newly established vehicle manufacturing plant will likely be snapped up by parts suppliers working on JIT production strategies. However purchasing a factory close to a mine that is in its moribund phase may produce only short-term benefits before being saddled with prime real-estate in the ghost town that follows the mine shutting down operations.

The cyclical element refers to where the purchase occurred within the real-estate cycle. The moving curve from buyers to sellers’ and back to buyers’ market can severely impact ROI and cap rates. Even so, the purpose of property acquisition may be for long-term revenue in which case the point on the cycle plays a smaller role. Commercial property, like shares, has a ‘price-to-earnings’ ratio (the rent). Real-estate prices can fluctuate in the short-term, but in the long run, property prices and its intrinsic value is driven by rental income.

All three elements are interwoven with broad-based economic performance. For example, prospects for office space demand influence the take-up of existing and new space. Yet those prospects remain dull in the wake of SA’s increasing unemployment figures which breached the 25% mark in Q3 of 2012.

Over two billion cups of coffee are consumed in the world every day. Traders bank on this relatively consistent consumption to predict future supply/demand ratios while trying to factor in the aforementioned unexpected variables.

Unfortunately no commercial property investor can accurately predict the future value of his investment nor can he predict the reliability of a lease contract. This makes commercial property investment both exciting and highly profitable for astute buyers.

Nevertheless, a careful analysis of the three elements mentioned above rather than gung-ho assumptions help mitigate risk. Drilling deep into regional and local business intelligence will offset some of the hazards would-be buyers will face - leaving more time to savour another cup of black gold.

Dieter Deppisch, Knowledge Factory Insight Analyst

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