Why invest in Industrial property?

Among the ‘bricks and mortar’ real estate asset classes such as residential, car park, industrial, commercial and retail/shopping spaces in Hong Kong, the price of industrial buildings is relatively low by comparison. With the decline of Hong Kong's industries over the past few decades, the market demand for older industrial buildings has decreased. However, these same buildings have strong price-growth potential after undergoing ‘revitalisation’; renovated industrial properties benefit from higher margins on redevelopment costs and solid rental returns. At present, the price of a commercial or office building per square foot can easily exceed HKD $20,000 to HKD $30,000. Currently, the price per square foot of industrial buildings is only a few thousand Hong Kong dollars. As long as the government continues to make changes to the use of industrial property, or if they introduce favourable industrial building redevelopment or conversion policies to meet Hong Kong’s changing social and economic needs, then the value of industrial buildings will be reflected in the price per square foot. There are, however, a number of important caveats to investing in an industrial real estate in Hong Kong. Continue reading for more information.

(1) Pay attention to supporting businesses in the premise and district

There are two common ways to profit from investing in industrial property. One common way is to buy industrial buildings below market value, thereby adding instant equity on purchase. The other common way is to find unconverted, disused industrial buildings that have the potential to be acquired by much larger investors or companies. If you purchase the former, you should pay attention to two points. Firstly, you must understand the maintenance and management costs of the entire industrial building and whether the specific unit you are looking to buy has important maintenance or structural problems that need to be addressed. So before entering the market, prospective buyers should inquire about the actual situation of the industrial building and the specific unit and hire professional building inspectors and/or qualified and accredited structural engineers if necessary. When doing your research on the feasibility of the investment, try not to rely on information from only one source and instead get as much information from a range of different sources, for example the property broker, the landlord and any tenants adjacent to the property etc.

Secondly, investors must understand the surrounding environment of the industrial building, including whether the transportation is convenient and whether there are enough restaurants near the industrial building. These are the primary concerns of many tenants which can affect the industrial unit’s value in the market. It should also be noted what kind of businesses exist and the type of trading that occurs on the floor of which the industrial building belongs. If multiple units on the floor are engaged in retail business then the flow and footfall of customers can be complex. Additionally, if there are printing factories, pharmaceutical factories, or wood manufacturing factories in operation or if there is often a lot of noise, unpleasant smells, or the floors are piled with a lot of clutter, then these factors will all affect the appeal, market overall value and rental rate of the industrial unit.

Some investors buy an entire industrial property with the intention of holding and on-selling it for a profit later to either a big developer or a much larger investor who will invest in the building’s revitalisation. Aside from potential opportunities to achieve purchase discounts (equity on purchase) through economies of scale, another reason why investors choose to purchase entire buildings is that sometimes the collective ownership will be lower. Buyers can negotiate more easily with either a single owner or at least fewer owners; negotiating with one or a small number of owners can sometimes help buyers reach a deal with the owners in a shorter amount of time.

(2) The maximum loan for any industrial building is 40%

After selecting the building unit to buy, the next step is the mortgage. There are two major differences between an industrial building mortgage and a normal residential mortgage. Firstly, banks perceive industrial loans as being riskier compared to residential loans. This is mainly because the business world can be volatile and the commercial viability of the tenant’s business and their profits can be less predictable or consistent year over year. In other words, if a tenant’s business is suffering and they can’t afford to pay their rent, this can affect the commercial viability of the landlord’s investment which can then affect the landlord’s ability to repay their mortgage. Because of this, banks prefer to adopt a more conservative approach when issuing loans for industrial properties, i.e., they will use lower loan-to-value ratios and higher interest rates compared to any loans issued for residential buildings.

Secondly, according to the existing government regulations, the maximum mortgage ratio for all non-residential transactions is 40%. That is, if a prospective investor wishes to invest in an industrial building, he or she must be prepared to pay at least 60% of the transaction price. For example, for a HKD $2 million unit in an industrial building, the down payment is HKD $1.2 million. If the buyer has other mortgages, the maximum mortgage will be reduced by a further 10%. In addition, the contribution income ratio and stress test limits for buyers of industrial buildings are stricter than those for residential buildings; at 40% and 50% respectively (up to 50% and 60% for residential).

Since down payment (deposit amount) on industrial property makes up a larger portion of the total purchase price compared to residential property, this can help industrial property investors improve their cash flow position. However, it also means that if the value of an industrial building increases, any new buyer will have to contribute even more for the down payment when the building is resold.

While the higher cash deposit requirements can help with improved cash flow, the reality is that not all banks accept mortgage applications for industrial buildings. Some mortgages may be declined based on the overall quality of the industrial building. Banks will be more conservative in approving mortgage applications for older industrial buildings. Buyers are advised to check with their bank first before they get too involved in discussions and negotiations with vendors.

Another point to note is that banks may refuse to approve mortgages for industrial properties that have been sublet. In recent years, a number of sublet industrial buildings have emerged in the market, i.e. larger industrial buildings have been subdivided into smaller units and renovated while the original tenants sublet the property, or part of it, before the building is put back on the market. Banks may be concerned about the impact this has on the overall quality of industrial buildings, such that developers may have tried to cut corners to save on redevelopment & revitalisation costs thereby increasing the risk of possible fire safety regulation violations, etc. In this case, banks will usually want to inspect the industrial buildings first. Buyers are advised to check with their bank for mortgage details before finalising the deal.
 

(3) Short-term transfers without additional special stamp duty

Purchasing and on-selling (also known as ‘flipping’) industrial units will not incur special stamp duty (SSD) tax unlike with residential properties. The reason for this is that industrial buildings are non-residential properties and are only subject to the progressive ad valorem stamp duty (AVD) of up to 8.5% on non-residential properties (see table below), not the current SSD and Buyer’s Stamp Duty (BSD) on residential properties. See the complete guide to Hong Kong stamp duty.


Non-residential property stamp duty rates