Commercial Investing guide
Commercial property can be a great investment for those looking to build passive income—with the potential for impressive returns in the long run. However before you dive in, it’s important to understand the basics. In this article, Rethink Investing explains how to get into commercial property investment.
Why invest in commercial property?
Commercial properties offer the highest cash flow in Australian real estate—offering exceptionally high yields compared to residential. Here are the main reasons for this.
- The recent tightening of the commercial market has resulted in yield compression. This is effectively capital growth.
- The option to negotiate long leases as some commercial properties boast three, five and even more than ten year leases. With this, you have the opportunity to build annual rental increases into the contract.
- Commercial tenants guarantee security and with it, strong returns. As well as being responsible for all outgoings, a well-known commercial tenant will have a reputation to uphold—whether that’s Coles, Australia Post, BWS, IGA or Suncorp. Residential tenants can be far more unpredictable, leading to unforeseen costs on your end.
When you secure a long-term commercial property investment, you could see greater returns. Some commercial property loans can be fully paid off in as little as ten years: after which time that passive income will go straight into your pocket.
The basics of commercial property investing
What is a commercial property investment?A commercial property investment is specifically used by an investor to generate a profit. In Australia, commercial property generally takes the form of a building which fits within a certain property type: office space, retail, industrial, and specialty. However, there are many other sub categories such as medical, hotels, short-term accommodation and more.
Types of commercial properties
Commercial properties generally fall into one of four distinct asset classes. Each asset type has its own set of risks and rewards, as well as being subject to economic trends. As an investor, it’s a good idea to familiarise yourself with the basics of each, as well as understanding their relationship to the current market. This will help ensure that your commercial property investment is a winner.
Let’s take a closer look at each of them.
1. Office space
Commercial office spaces could mean anything from a CBD office tower to a small suburban office. Investing in commercial office space, it’s important to consider key market factors like employment growth, business confidence, and workplace flexibility changes—something we’ve all learned to adapt to with COVID-19. A quality office building will be:
- Located close to food and retail amenities.
- Near transport networks, or ample parking for employees.
- Set in pleasant surroundings with plenty of natural light.
- Well-maintained (saving repair costs since tenants finance these themselves).
- Close to other similar businesses.
2. Retail
Retail tenancies could be anything from entire shopping centres all the way down to a 50m2 hairdresser’s shop front. In the retail sector, property market drivers include consumer confidence, interest rates, time of year, surrounding tenancy mix, and income growth. Investor demand is influenced by low interest rates, the strength of the housing market, and the economy’s general health. High-quality retail properties will be:
- Highly visible from a main road or in full view if inside a mall—with access to ample parking.
- Close to quality anchor tenants (also known as key operators). If inside a mall, the investment should have low vacancy rates.
- In an affluent location: wealthy people have more disposable incomes.
- Positioned in high population growth locations.
- Occupied by well-established tenants, likely to renew their lease long-term (with strong covenants in place).
- Able to offer zoning options, multi-tenant uses, or the potential for future development.
3. Industrial
Industrial investment properties can range in size, and in their potential uses. Industrial commercial properties could be anything from a small industrial site through to a major logistics and distribution centre. For industrial property investors, a prime consideration is the quality of road networks. Freeways and motorways provide access to metropolitan areas, as well as connecting prospective tenants to ports and cargo docks. Key property market drivers include the economy, access to important infrastructure, and interest rates. A quality industrial property investment will:
- Be in close proximity to food retailers and other amenities within population centres.
- Be well-maintained and secure, with an office area, a kitchen, toilets and air conditioning.
- Include an external loading dock with heavy vehicle access and suitable height limits.
- Have minimal or no restrictions on water usage, discharge or noise. There should be no major environmental concerns associated with the property investment.
- Offer flexibility for future additional offices or showrooms.
- Boast high ceilings, as many tenants use stacking shelves in warehouse space.
4. Specialty
Specialty commercial properties could be anything from a service station to a childcare centre, to a hotel or pub. As an investor, key factors to look out for include business confidence in that particular sector, interest rates, and the general state of the economy. Quality specialty commercial will:
- Be scarce to find. For example, if you are buying a childcare centre and there are three more under construction in the same suburb, the investment could present too many risks.
- Have a strong lease backed by a secure tenant.
What to look when investing in commercial property
Location
When it comes to investing in commercial property, location is vital. It could make or break your investment. Depending on the type of commercial investment, you will need to satisfy different criteria each time. Learn more about the different commercial property types here.
Vacancy
Vacancy rates can be used as a barometer for what’s going on in the area. A lot of vacant shops, warehouses and offices could indicate future difficulties in securing a new tenant, should you lose yours.
But don’t forget—commercial properties are still available even when vacant! The reason? There’s an owner occupier market, just as there is with residential property. Many businesses buy the property they occupy. When they sell, the building goes to market again.
Building
Pursue a modern building with a well-maintained exterior and interior, where minimum upkeep is required.
Tenants
The value of an investment property is often closely tied to the strength of its lease, and tenants with previous long-term leasing arrangements are highly desirable. It’s a sign that the business is performing well, and that they’re unlikely to move if they’ve built up a certain customer base in the location. For example, a dental surgery, veterinarian or beauty salon.
Property fitouts can also run into the hundreds of thousands of dollars. Such investments mean that tenants will be reluctant to leave, even if they find cheaper rent down the road. It’s in their best interests to stay long-term.
How to add value to your commercial investment
- Buying under market value immediately increases the value of your investment, as it’s already worth more than the purchase price.
- Some tenants occupy industrial assets and build mezzanines as a way to create more space, or to provide an office for their business. Many are built without council approval and cannot technically be added to the square footage of the building by law. Do your research here: there may be a chance to secure a lower sale price and retrospectively approve the add-on through council—equalling an instant increase in the property’s value.
- By adding more square meterage to the property or dividing up space, you can add significant value to your commercial investment property.
- Add highly desirable assets such as storage or parking. Both are highly sought after by tenants, and could result in a long-term lease and higher rental returns.
- Rental increases can have a huge effect on your investment portfolio, as it increases cash flow and capital growth.
- Increasing the length of your lease will increase the security on the property, which will mean investors will value your property at a higher rate.
How to invest in commercial property in Australia
For those starting on their investment journey, the expertise of commercial buyer’s agents can pay dividends. A commercial buyer’s agent can help introduce you to the commercial property market, acting as a guide as you navigate the investment process. Here’s how to invest in commercial property in Australia, with the help of an investment property expert.
1. Undertake due diligence
First, your buyer’s agent will research the tenant and their business—past and present. How long have they been on the premises? Are there any risks associated with the tenant? They will request an arrears report and establish whether the tenant has paid their rent on time, as well as whether they’re paid up to date. Remember: in commercial property, the tenant is everything. It’s important to purchase a property which will generate interest from quality tenants. Your buyer’s agent can help you conduct a complete analysis of potential tenants.
2. Share expertise on the various commercial investment types
A good buyer’s agent will educate you on the different types of commercial properties, including the associated risks and benefits. Each asset class exists within a certain stage in a broader cycle; a knowledgeable buyer’s agent can advise you on the solidity of your investment for years to come. Or, they’ll have rental income calculator tools at their disposal to assist you.
3. Understand the locations you’d like to buy in
It is vital that your buyer’s agent understands the market value of the areas you’re interested in, including what similar properties in the area lease and sell for, upcoming infrastructure development, and population growth prospects. Depending on your personal criteria as the client, a buyer’s agent will have the connections to find a property that suits your needs: whether you’re looking for high growth areas like capital cities, high cash flow, or a more diverse portfolio.
4. Source properties on your behalf
Experienced buyer’s agents tend to have larger networks, delivering more off-market properties to investors. Off-market properties are extremely valuable to you; it means less competition.
5. Support you through the whole sales process
A buyer’s agent can be an important source of support for investors, helping you through the entire sales process. From assisting with financing requirements to negotiating the contract’s terms on your behalf, a commercial buyer’s agent is an invaluable asset.
6. Link you up with the best property management options
Not only do commercial buyer’s agents have connections with off-market properties; they have a wealth of contacts in all aspects of the commercial field.
7. Provide long term support
After settlement, they will continue to support you with your property, ensuring you maximise cash flow for the duration of your ownership.
Pros of commercial property
compared to residential
You generate passive income sooner
High quality commercial property has the potential to pay itself off in ten years, rather than the typical thirty years a residential property may take. After the debt is paid, all that cash flow goes straight into your pocket rather than to the bank.
Higher rental income
Commercial property has always offered higher yields than residential. With commercial demand increasing and interest rates at an all time low, yields have reached levels you would never see in residential. In the post-COVID climate, commercial yields are upwards of 6-9%.
Negotiable lease terms
Because contracts with tenants are incredibly fluid, you can use this to your advantage and secure a great deal—if you know what you’re doing. This is where a buyer’s agent can step in to help maximise your lease team.
Tenant pays outgoings
Unlike residential property where the landlord often pays for outgoings like water usage, council rates, repairs and maintenance, most commercial tenants sign ‘net leases’ which require them to pay all outgoings.
Longer leases
A commercial lease term can span anywhere from three years (usually the minimum) to as long as fifteen years.
Higher quality tenant
Tenants have a vested interest in the property because it’s their livelihood, which means they are more likely to look after it. Businesses that have a reputation to uphold, so they are also more likely to pay their rent on time; it’s not a good look to the public if a large company doesn’t pay their rent accordingly. For these reasons, commercial leases can hold fewer risks than that of residential.
Annual rent increases
Most commercial property contracts have fixed annual rent increases built in. This is often around 3-4%, or is linked to CPI.
Diversification
By holding both commercial and residential properties in your portfolio, you are better placed to mitigate risks if either of these markets take a fall.
Tax benefits
Commercial investors have the opportunity to claim thousands of dollars in tax benefits, due to depreciation.
Variety of ownership structures
You can purchase through a variety of entities including self-managed super funds, discretionary trusts, a company or individuals in a partnership.
Highly accessible to all investors
Commercial property is available at multiple price points, from a small warehouse in the five figures to a large shopping centre in the millions.
Cons of commercial property
compared to residential
Higher deposits needed
The loan value ratio is much lower for commercial property. Residential property is deemed less risky—hence why 90-95% loans are available in the commercial area. Residential property can be purchased with as little as $50,000 as a deposit to cover all necessary costs. Commercial, on the other hand, requires $250,000 as a minimum.
Complicated lease terms
When you purchase a commercial property, unlike residential, you are entering into an agreement with the tenant and their business. Every term could be up for negotiation and you will need a seasoned lawyer and negotiator in your corner to make sure you understand what you’re signing up for.
Sensitive to economic conditions
Commercial property is directly linked to what’s happening in the economy. During COVID for example, our specialists have seen a decline in demand for certain office assets and retail assets. This has been the result of more people working from home and shopping online. However, where consumer demand for these assets has fallen, others have fared incredibly well.
Industrial assets such as warehouses have flourished, with growing demand for online companies needing storage to park their goods. At the same time, smaller offices, coffee shops and local supermarkets in suburban areas have done incredibly well as people are staying close to home.
Reduced capital growth
This is tied to a few different variables. Business confidence, the strength of the lease and the state of the economy are just a few examples.
Potential for longer vacancies
Signing a commercial lease is a huge financial commitment for tenants, and commercial property has increased exposure to economic cycles. For these reasons and the management that the end of a lease requires (where you may need to conduct repairs or maintenance), you need to be able to handle longer vacancies.
Harder to sell
Commercial property is traditionally seen as riskier; it requires a deeper understanding of economics and business compared to residential. The best time to sell is at the beginning of a lease, with a tenant who is doing well.
5 ways to maximise commercial returns
1. Build and maintain your relationships
One of the biggest points of difference between commercial real estate and residential real estate is that it is a relationship based business. In knowing this, you’ll be one step ahead and able to secure the best deals as you work with the seller. Commercial requires you to build rapport with brokers, who send you their best off-market deals.
2. Purchase at the right time in the right industry
At any point in time, different asset classes and sectors perform better or worse. For example, many office markets are performing worse than industrial commercial real estate markets right now .
3. Purchase in quality areas
Don’t just chase all out yield! For example, a 10% net yield in a tiny regional town might not grow at the same rate as a 6% net yield in a capital city.
4. Purchase an asset that can be easily re-let
If you are not confident in replacing a tenant in worst case scenarios, it might not be the deal for you.
5. Do your research
It’s on both the tenant and the investor to make sure the property has rock solid cash flow. Due diligence is there to make sure the asset itself checks out, compared to the price you are looking to pay.
How much money do you actually need to get into commercial property?
You can get into the commercial property market with around $175K. So that’s a 30% deposit, plus stamp duty, solicitor fees and your building and pest inspections. That figure is based on a $500K property boasting 100 square feet (perhaps a small physiotherapist or office or warehouse located in a capital city with high population growth).
These properties are good quality with smaller tenants and could still offer three-year lease options, so they’re a great investment all around. As for finance options, some banks are offering 80% leases now.
We do recommend to our clients that $200k is the minimum as it means you can purchase a slightly higher better quality commercial investment. However, once you add it all up, you can enter the market and start generating returns all for a relatively modest amount.
Our Commercial Property
Investing Checklist:
- Always check for competition. You wouldn’t purchase a pharmacy if there’s two more being leased right around the corner.
- Check demand in the area you are considering investing in. If there’s a lot of nearby vacant space, there is an elevated risk of future vacancy.
- If you are purchasing a retail asset, make sure it is located near key operators to attract customers. This goes for both strip shops and those in malls.
- Always consider how long it would be to find a new tenant should your current one leave. Checking comparable rentals on the market is a handy start.
- Never pay too much for the property. Check rental and sale square metre comparables to confirm.
- Always check the payment history of the tenant to gain confidence in the business itself. Make sure there are no issues with the building or the strata (if applicable) by carrying out due diligence via building and pest reports, as well as strata reports.
- Speak with local lease managers to find out any market trends that might affect your property.
