Commercial properties are more vulnerable to economic shocks than residential properties and are, therefore, considered higher-risk investments. The upside, however, is that they also offer greater returns.
Taylors Strategic Partner, Michael Sik - Financial Adviser and Owner of FinPeak Advisers - takes a good look at the other side of property investing, commercial property.
What Is Commercial Property?
Commercial property includes office buildings, warehouses (industrial), shops (retail), childcare and hospitals (social infrastructure) and is generally regarded as a higher risk asset than residential property. The main difference between these two types of properties is that commercial properties are used primarily for business purposes and residential properties are used as homes. Consequently, commercial properties are more vulnerable to economic shocks than residential properties and are, therefore, considered higher-risk investments. The upside, however, is that they also offer greater returns.
On the plus side, under a commercial property lease, it is normally the tenant who wears many of the ongoing costs such as council rates and maintenance. The downside is that a commercial property purchase will attract the Goods and Services Tax (GST), as will rent, so be prepared to add 10% onto the cost of a commercial property purchase.
Pros Of Investing In Commercial Property
#1 Annual Rent Increases – commercial leases include fixed rental increases which ultimately increase the value of the property and typically fall in the range of 3 to 4% which is higher than the current rate of inflation.
#2 Rental Yields – commercial property offers yields of around 5% to 12% whereas residential property offers yields of around 3% to 5%. Given the cost of borrowing and average borrowing levels, you would expect commercial properties to be positively geared from day one.
#3 Investment Returns – if you consider that rental increases can be 3% to 4% which forms a foundation to the valuation of the property and rental yields are between 5% and 12% the total return profile for this asset class could be potentially around 8% to 16% pa. This makes this asset class quite attractive when comparing to other investments.
#4 Lease Length – commercial properties generally have longer lease lengths anywhere from 3 to 10 years on average compared to residential where most tenants have a 6 to 12 month lease. This is important as it is typically harder to replace a commercial tenant and the rental income is a factor when calculating the property’s value.
#5 Outgoings – unlike residential properties, the tenant is responsible for covering their share of the outgoings (council rates, utilities, strata).
#6 Better Tenants – commercial tenants use their rented premises to run a business means they have a stronger incentive to take care of the property.
And The Cons Of Investing In Commercial Property
#1 Vacancy Periods – commercial property will have longer vacancy periods and this means the landlord will need to cover outgoings whilst the property is vacant.
#2 Lease Terms – these can often be quite complex with almost everything up for negotiation like fit out costs and rent free periods and will generally involve lawyers to draw up the contracts.
#3 Repairs And Maintenance – although the tenant wears most of these costs, if an upgrade is needed to attract better quality tenants then this asset can be quite costly and can cause a disruption to the tenant’s business operations.
#4 Lower Loan To Value Ratio (LVR) – commercial investment is deemed higher risk than residential investment, banks generally require a minimum deposit of 30% for commercial properties and commercial loans generally attract higher interest rates and administrative fees.
#5 Exposure To Economic Shocks – while people always need a place to live, demand for a business’s goods and services ebbs and flows, which means that demand for commercial property is more elastic than demand for residential property.
#6 Expert Advice – commercial investors need to have a deeper understanding of the broader economy than residential investors, because the demand for commercial properties is more sensitive to economic shocks. This means commercial investors generally need to conduct more research before buying a property.
This link takes you to a video from the CEO of one of Australia’s largest direct commercial property fund managers (Charter Hall) that discusses some of the basics when looking at this asset class.
Ways To Invest In Commercial Property
#1 Direct – you could use some of your savings (including funds in a self managed super fund -SMSF) to purchase a commercial property like an office suite or a small shop front, even a single car park. However, for most of us, the idea of owning an entire office block or large shopping centre is quite out of reach unless you pool your funds with other investors (see below). This is the most illiquid form of investment structure meaning that it may take some time to sell your investment in order to get any of your funds back.
#2 Direct Property Fund – A direct property fund is a managed investment scheme where multiple investors’ money is pooled together to purchase property assets. Ownership is shared between investors based on their investment portion, but the actual investment is determined by the fund manager. This too can be funded from savings and superannuation.
#3 Listed Property Fund – A listed property fund is a commercial property or portfolio of properties listed on the Australian share market (ASX). These are also known as Australian real estate investment trusts (A-REITs). Like direct funds, A-REIT investments are made by a fund manager with pooled-together finances from investors. This is the most liquid form of investing in property meaning you can easily sell your shares if you need your money back or if you want to reinvest your dividends (realised capital growth and rental income) let the power of compounding growth work its magic. This also can be funded from savings
Should You Invest In Commercial Or Residential Property?
If you’re new to property investment, it’s probably best to buy a residential property first, as the associated risks and level of business knowledge required are much lower. On the other hand, if you’re an experienced investor with multiple residential properties in your current portfolio, investing in the commercial market would make sense, as you could improve your cash flow – thanks to higher rental yields – whilst diversifying your portfolio and reducing your exposure to downturns in the residential market. It also depends on what you want from your investment, commercial properties pay higher income which means there will be some tax implications whereas residential property has lower yields and deferred capital gains meaning the bulk of the tax is paid when you sell your property.
The commercial property market is necessarily off-limits to mum and dad investors; rather, that those who’d like to take the plunge should seek advice from a team of professionals before doing so.
Like To Learn More?
For more information, please contact Michael Sik on 0404 446 766.