The 9 pros and cons of investing in commercial property
With the residential property market unsettled it has some investors wondering if now is the time to invest in the commercial property market?
There is considerable difference between commercial and residential property investing. Whispers of high rental returns and longer tenancy periods for lower outgoings have investors ears pricked and there is no doubt, diversifying or buying into commercial real estate can be a great annex to your portfolio.
But as RealCommerical Journalist Euan Black said “Everyone from your solicitor to your barista has an opinion on where ‘residential’ prices are going” but “ask a random passer-by what they know about the ‘commercial’ market and you’re likely to be met with little more than a scratch of the head.”
So for the unwitting or novice investor buying a commercial property can be a daunting and complex process, fraught with risk. However, for the well-advised commercial property can offer great reward. And to minimise your risk and maximise your reward we have broken down the key pros and cons of investing in commercial property.
1. Higher rental yields
The average rental return for residential properties across Australia’s capital cities is 3.6% according to CoreLogic RP Data. In contrast, it’s not uncommon to get anywhere between 6% and 10% gross rental yield for commercial properties.
As a result, commercial investments are more likely to be cash-flow positive than their residential counterparts.
2. Longer Leases
Commercial properties can attract long-term leases of three to five years or sometimes more. If you attract and secure stable and reliable long-term tenants, such as large corporations, government departments or well-known reputable brands, you can be sitting pretty for years to come.
3. Lower Outgoings
One of the biggest benefits of being a landlord of commercial property is the lower outgoings. Tenants are usually responsible for all outgoings including the more expensive council rates and any owner corporation’s fees.
In addition, usually, if a tenant wants to make substantial interior changes to a premise, they will be responsible for the fit out and the associated costs and will have to ‘make good’ at the end of their lease.
4. Portfolio Diversification
If you have already have a residential property portfolio, purchasing a good quality and well located commercial property may be a way to diversify your portfolio further. And to ensure you are getting the best you can afford, seek advice from the ‘experts’ like solicitors, commercial mortgage brokers and buyer agents.
1. Increased Vacancy
It’s not uncommon for commercial properties to have long vacancies, which means you will need to cover all the costs during this period. Commercial property can sit vacant for 6 months or more whilst waiting for the right tenants.
And for anyone that lives close to a “High Street” of shops you will probably have witnessed both ends of the scale, with successful businesses leasing for years and alternatively shop fronts that are frequently empty because they just can’t seem to get the right long term tenants!
So you need to be prepared and have a cash buffer available to cover a property’s outgoings without the support of rent.
2. Complicated Lease Terms
While there’s little variation between residential leases, the difference between commercial leases can be huge, with pretty much every term up for negotiation. Consequently, commercial investors have to work very closely with their lawyers when drawing up a lease.
3. Upfront Capital Required
Whilst there is a real price range in commercial properties, depending on location and type (retail, cafe, office, factory, warehouse, etc.) the one thing they all have in common is that banks and lenders all want more money upfront.
Banks consider commercial properties higher risk and therefore their LVR (Loan Value Ratio) is lower. When borrowing for a residential property you can borrow up to 90/95% of the property’s value but for a commercial property is not uncommon for the lender to require a 30% to 40% deposit, therefore only lending 60-70% value.
We recommend you engage an experienced commercial mortgage broker to get you the best deal based on the security type and your risk profile.
4. Reduced Capital Growth
Whilst you can find ‘experts’ to argue this point, either way, the majority agree that commercial properties typically experience slower rates of capital growth than residential properties.
The capital growth of commercial properties depends on a number of factors and can be significant either way. In contrast, any price falls associated with residential properties are generally less dramatic and usually, happen progressively over a longer period of time.
5. Economic Conditions and Infrastructure changes
Commercial property is more susceptible to economic shock. Demand for business goods and service can fluctuate dramatically based on the strength of the economy. Demand for commercial premises usually falls during an economic downturn, but people always need a place to live.
In addition, as the pool of tenants is smaller new property coming on the market in the same area can reduce your pool further and even existing tenants may look to upgrade or expand.
Changes in infrastructure can be positive and negative, improved infrastructure can attract tenants to the area, but it can also lure tenants from existing areas if other areas are benefitting from roads, transport or other major upgrades.
What to look for if investing
So you’ve weighed up the pros and con’s and decided to take the plunge and invest in commercial real estate. As with any investment, it is crucial to get your due diligence right and part of that is purchasing the right property from the get-go. We share the top five things to look for in a location before even considering the property:
- Councils that have significant expenditure in place to improve infrastructure
- The population growth of an area, which impacts the amount of foot traffic
- Suburbs that are experiencing gentrification
- Car parking – where is it and how many spaces
- Depending on the type of commercial property, proximity to supermarkets/shops and transport
Investing in commercial property can mean significant rewards with high rental returns and longer tenancy periods. However, we recommend getting financial and legal advice along your commercial property investment journey. And as with any investment, a robust due diligence analysis must be completed before negotiating for the property.