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Is now the time to invest in commercial properties?

November 1, 2012

With our residential property markets in a slump over the last few years, some investors are wondering if it’s worthwhile considering commercial property.

They 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. All this makes commercial property sound very appealing.

So let’s do a Q&A to find out a bit more:

Q: What are commercial properties?

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

My experience shows that commercial real estate has – both historically and in recent times of economic turbulence – proven to be significantly riskier for investors than residential real estate.

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

A: These 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 (owner-occupier) demand-driven in residential property and fluctuate over time related to yields available from other investments and the prevailing interest rates.

As most commercial rental increases are usually pegged to the rise in the CPI, your rent increases at around 2% or 3% each year, stifling your capital growth. Then when the economy falters and businesses languish, commercial property tends to be out of favour and drops in value.

Q: If the total return is similar, why not go for the investment with the higher cashflow, 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 machine” to replace their personal exertion income. This is much easier to do with capital growth, which is not taxed, than with cashflow, 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 beginner 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 subtract rates, taxes, insurance, etc).

Professional investors require a higher rental return to make up for this type of property’s inferior capital growth and longer vacancy factors.

With commercial properties, the tenants usually pay all the outgoings such as rates, taxes and insurance.

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 restore the property to its original condition at the end of the lease.

Leases for commercial properties tend to be for longer periods, often three to five 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 two you may have a residential property vacant. How often have you seen a shop in your local shopping centre vacant for months 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 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.

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. This is 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 could buy cheap shops or factories in secondary centres, but they will usually have secondary tenants who are likelier 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.

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.

While I have a substantial commercial property portfolio, I wish I had moved into commercial property a little later in my investment life as this type of property is more suitable for investors who already have a substantial asset base and have transitioned to the cashflow stage of their lives. It also makes a great investment in your Self-Managed Super Fund if you have substantial equity in it.

Credits: Michael Yardney

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