Wednesday, 14 November 2012

Is it time to consider investing in commercial properties?

With our residential property markets in a slump over the last few years, some investors are wondering if it’s worthwhile considering commercial property as an alternative.
So lets take a look...
Potential investors see that these are the type of properties owned by people in the BRW Rich 200 List and the big institutions; and they hear of high rental yields, long term leases and tenants paying the outgoings. This makes commercial property sound very appealing.
So let’s do a Q&A to find out a bit more about this asset class:

Q: What are commercial properties?

A: Commercial properties consist of shops (retail) factories and warehouses (industrial) and office space (commercial).

Experience shows that commercial real estate has both historically, and in our recent times of economic turbulence, have proven to be significantly more risky for investors than residential real estate because of businesses (potentially your tenants) failing and/or closing down.

Q: What’s the fundamental difference between the 2 types of investment?

A: They are very different investment vehicles. Residential property is a high growth, low yield investment while commercial property is a higher yielding but low growth investment.

The values of commercial properties are yield driven rather than demand driven in residential property and the values fluctuate over time related to yields available from other competing investments and the prevailing interest rates of the time.

With most commercial rental leases increases are usually pegged to the rise in by C.P.I. Your rent therefore increases at around 2% or 3% each year. This has the effect of stifling your capital growth. Then when the economy falters and businesses languish commercial property tends to be out of favor because of the risk of your tenant going broke and hence they drop in value.

Q: If the total return is similar, why not go for the investment with the higher cash flow, in other words commercial investments?

A: The fundamental job of property investors is to build themselves a substantial asset base to one day create a “cash cow/machine” to replace their personal exertion income. This is much easier to do with capital growth that can be refinanced and which is not taxed, than with cash flow from commercial rent which is taxed.

Q: How else does commercial property investment differ from residential real estate investment?

A: There are considerable differences between the two types of property which may make them a less safe option for beginning real estate investors:-

  • Commercial properties tend to yield a higher return than residential properties – usually between 7% and 10% net compared to residential properties which yield 4.5% to 5% gross (then you subtract rates taxes insurance etc. to net about 3%).
  • Professional investors investing in Commercial property require a higher rental return to make up for this type of property’s inferior capital growth and the longer vacancy factors.
  • With commercial properties the tenants usually pay all the outgoings such as rates, taxes and insurance. But this merely offsets the lower Tax deductions for Depreciation available on residential property.
  • Because your tenant conducts their business from your commercial property, they tend to look after it better by maintaining the property including painting it and most leases require the tenant bring the property back to its original condition at the end of the lease.
  • Leases for commercial properties tend to be for longer periods, often 3 to 5 years as opposed to the one year lease you can get from a residential tenant.
  • However when vacancies occur in commercial properties they are often for considerably longer periods than the week or 2 you may have a residential property vacant. How often have you seen a shop in your local shopping center vacant for months or even years on end? And when you do find a tenant you often have to offer them an incentive such as a rent free period or a free fit-out to entice them to lease your property.
  • Lenders will usually only lend up to 70% of the value of commercial properties and I don’t know of any mortgage insurers who will lend on commercial property because they consider them to be higher risk.
  • Interest rates for a loan on commercial properties are usually higher than for residential properties- sometimes around 1% higher.
  • Investors need significantly more equity to purchase a commercial property. Partly because a bigger deposit is required and also because a good commercial property usually costs significantly more than a house or apartment. Sure you can buy cheap shops or factories in secondary centers, but they will usually have secondary tenants who are more likely to go broke and leave you with a vacancy.
  • The cycle for commercial properties is different to that for residential properties and is more dependent on the general economic factors than the residential market.
  • The lease required for a commercial property is a much more complex and is often prepared by a lawyer and at significant cost.
  • It’s easier for the average investor to pick a top performing residential investment. Most know what to look for in a residential property but few would know what a tenant looks for in a good commercial or industrial property unless they have conducted their own business from one.

In summary:
There is a place for commercial property in an investment portfolio but it is more suitable for investors who already have a substantial asset base and have transitioned to the cash flow stage of their lives. It is important to remember that it is higher risk and requires a differnet set of knowledge and skills to make it work for you as an investment vehicle to secure your future.
But it makes a great investment to consider in your Self-Managed Super Fund if you have substantial equity within the fund.