Have you considered commercial property investment? Well, you’re not on your own. Many property investors have considered adding a commercial property to their portfolio.
Commercial property investment can be a great addition to a portfolio enabling both cashflow and diversification. However, it can be a high-risk endeavour for those who don’t know what they’re are doing.
Let’s take a quick look at the difference between commercial property and residential property before we begin. Commercial property is generally a property used for business activities. These can include industrial properties, retail properties, offices and hotels etc. Residential property has houses, units, flats and more, and contains properties that can be occupied as a residence.
Read the definition of commercial and residential properties for your taxation purposes.
Investing in commercial real estate in Australia takes a different level of due diligence and research than residential property. Purchasing directly from commercial property developers may pose a higher risk if there isn’t an investing tenant.
Difference between Commercial Property Investment and Residential Property Investment
There are some critical differences between Commercial Property Investment and Residential property investment. If you are considering commercial property as part of your portfolio, you should be aware of these.
- Commercial Properties often have a higher yield.
- Rents are usually based on a per-square-metre rate.
- Commercial tenants will often be responsible for the property outgoings.
- Commercial leases are often for more extended periods and have rent reviews incorporated in the lease.
- Fitouts and renovations are often required for new tenants and are sometimes incorporated as part of the lease. This may be necessary to attract new tenants or to tailor the property to meet specific commercial tenants.
- Vacancy risk is higher with commercial properties, as there are fewer tenants available than a residential property.
- Financing a commercial property is more complicated. Factors that need to be considered are more extensive deposits required, higher interest rates, specialist commercial funding.
As the above points out, there are some factors that investors need to consider. However, as outlined below, there are some advantages that commercial property investment offers:
- Strong and stable: Commercial properties often have longer leases and higher returns than residential properties.
- Diversification: Elevate your portfolio by adding a Commercial Property Asset other than the residential sector.
- Value-adding and developing: Attract higher-yielding tenants with additional fit-outs or renovations.
Commercial and Residential property investment definitions vary from from each other in a lot of ways.
Potential Negative Factors of Commercial Real Estate Investment
There are several potential negative factors associated with Commercial Real Estate investment that you need to be aware of when considering investing.
Entry Costs: Often, Commercial Properties have higher entry costs than residential property investment.
Lack of Comparables and Information: It is harder to find comparable information on commercial property investments. This is due to the different companies and types of property. It can therefore be more challenging to assess rental demand and Capital Growth potential. Estimating a fair price to pay for commercial property investment is difficult due to the lack of information available on comparables.
Lack of Liquidity: It can be harder to sell and find potential purchasers for commercial properties. Often commercial properties can take longer to sell, leading to a lack of liquidity in the investment.
Assessing the value of a property
Investing in commercial property vs residential property has different ways of assessing value. The Commercial Property Investment sector is driven mostly by yield. Therefore when determining the value to put on a commercial property, it is most often done by calculating the value from the yield.
The yields of commercial properties will vary across different areas and property types. In some places in very high demand, the rental yields can be as low as 3.0%, with some less in-demand areas having yields up over 10%.
Generally, the current rental is divided by a yield that is acceptable to the market-place when assessing the price. A property that is currently receiving $50,000 per annum, with an acceptable yield of 10% would be calculated as follows:
$50,000/10% = $500,000
Therefore, if you sought to get a 10% yield from the above example, the net price to purchase would be $500,000.
This formula can be used as a rule-of-thumb to calculate the right price when purchasing a property based on its rental yield.
Growth Drivers for Commercial Property
The factors that drive Commercial Property prices can be different from those for residential investment.
Population Growth: As with Residential property, population growth can be a significant driver of commercial property prices. This is due to the increased demand for goods and services in an area.
Demographics: Changes in demographics in an area can have significant effects on areas of commercial property demand. An excellent example of this may be an aging population in an area requiring more aged services providers.
Shifts in Consumer Behaviour: If you have been examining the effects of the Covid 19 lockdowns across Australia, you will have no doubt noticed the massive increase in online shopping. There has been a major increase in demand for warehousing space and a marked decrease in demand for many retail shop spaces caused by this shift in consumer behaviour.
Covid-19 and Commercial Property Investment
As touched on previously, Covid-19 has had effects on the Commercial Property market. Whilst there have been significant increases in demand for residential property resulting in price increases across the nation, the commercial property market has fared differently.
During the lockdowns, numerous employers began to use applications and technology to make working from home easier. This shift to higher numbers of people working from home has put negative pressure on the market for office space.
More people shifting to online shopping has decreased the demand for retail shopping space and increased the demand for warehousing space to hold goods for online businesses.
These changes highlight one of the key points that Commercial investors need to be aware of. The factors influencing demand for commercial properties are often different from those of residential investments.
Understanding the tenant demand for Commercial Properties
It is vitally important to have some useful information and research on the demand for a commercial property. Whilst there may be a tenant in place when you purchase a property, if that tenant moves out, how quickly and easily can you find a suitable replacement?
If your commercial property only has a small niche or small market to lease it, you may have issues in finding a tenant quickly, and this can lead to high holding costs.
It is safest to be in a Commercial property investment that has a large number of potential tenants that isn’t subject to large fluctuations in demand. This means that if the current tenant leaves, you can replace them easily without high costs and time delays.
Creating Demand and Increasing Rental Yield
In some instances, there may be the ability to increase the yield of a commercial property by renovating or fitting. This is seen in many cases where shopfitting is undertaken to attract a retail tenant. The ability to make changes to a property to create a higher yield may be a key part of your investment strategy.
A great example of this was seen recently near our head office in Queensland. A number of commercial warehouses were having issues in attracting suitable tenants due to a lack of demand for the spaces. A savvy landlord was able to attract a wholesale food exporter to rent his space but offering to build refrigeration and cold storage. By undertaking the renovation, the exporters were happy to sign a long lease at an increased rent amount.
Tips For Interested Property Investors
- Great demand from tenants: As mentioned above, you need to make sure that there is a good range of potential tenants. It is no good to have a high yield from the current tenant if you cannot replace them if they leave.
- Is there an ability to value-add or create growth: Is there an ability to make changes to the property and get higher rent or Capital Growth. This can be a very good investment strategy if done right.
- Research and Due-Diligence: You absolutely must undertake due diligence and careful research on any property that you are looking to purchase.
- Key Locations: Look to invest in locations that are in constant demand and not subject to population loss.
- Leased Properties: Purchasing a property with a high-quality tenant in place with a long term lease is a good strategy. This enables you to know the exact yield and also hopefully not have to find a new tenant for some time.
- Design Flexibility: The ability to change around a design or layout to meet the requirements of certain tenants is a big advantage and can mean the difference between having a tenant or being vacant.
- Depreciation and Taxation Advantage: You should look at the depreciation and taxation advantages associated with a property, as this can have a significant impact on your cashflow. Recently completed properties will often have higher amounts of depreciation available.
Factors to keep in mind when undertaking Commercial Real Estate Investment
Whilst there are potentially high yields to be achieved from Commerical Property, you must be aware that there are also other factors you need to keep in mind. You need to have an understanding of some of the commercial property market factors which can affect the vacancy and rental yield of your investment. You will also need to be aware of the more complex financing, higher deposits required, complex lease agreements and also the associated risks.
If you are looking at buying commercial real estate directly from the commercial property developer, this may present a higher risk if it is not already tenanted. You will need to assess the demand for this new commercial development very carefully.
Investing in Commercial Property Vs residential property is different, and there is a different level of research and due diligence that needs to be undertaken.
If you undertake the appropriate research, a commercial real estate investment can be a great addition to your portfolio.
As always, if you have any questions or would like to speak with an expert, please send through an inquiry.