Understanding Average Yields on Commercial Property
Explore the fundamentals of commercial property yields, offering insights into average returns and key metrics like ROI and gross yield. Whether you're a seasoned investor or new to commercial real estate, learn how to optimise your portfolio effectively.
What is a Good Average Yield on Commercial Property?
Commercial property has proven a lucrative investment strategy for decades. From warehouses to retail premises, these properties can rear a dependable, long-term cash flow that assists owners with other ventures. Many also prefer commercial and industrial sites over residential property investment alternatives due to higher yields surmounting financing costs (rather than relying on depreciation and other deductions to break even).
But this doesn’t automatically translate to all areas of commercial real estate.
As with any investment, we must first understand the benchmark in commercial property returns to assess the profitability of a portfolio. In this article, we take a look at the average yield on commercial property and how to value potential investments across Australia.
What is ROI & Yield in Commercial Property?
Return on investment (ROI) refers to the cash flow you receive – or will receive – from a commercial property after accounting for operating, financing and maintenance costs. Also referred to as the capitalisation rate or net yield, by dividing the profit reared from the investment by the cost of obtaining the investment, you receive a ratio gauging the quality of commercial property in your portfolio.
Another standard metric slightly different to ROI is gross commercial property yield. Gross current commercial property yields will be much easier to calculate as they don’t factor in the same individual costs; annual rental income is simply divided by the property value.
As it focuses on the net income that the property generates, ROI proves more effective than gross yield when looking at how to value commercial property in Australia against its purchase price. It is an effective solution to determine how much you receive for the amount you put forward, even before investing any money.
Try our free rental yield calculator tool
What is Considered ‘Good’ Commercial Property Yields?
As mentioned above, the average yield on commercial property can be significantly higher than residential property yield. Where single-family homes are known for their net yields of between 1% – 3%, the average net yield on commercial property investment in Australia is anywhere between 5% to 10%.
When business owners are tenants, generating substantial income from the property, leases tend to be longer, and rental payments are often higher. Savvy commercial property investors recognise the value in sites with strong yields, outperforming residential properties by covering financing costs and delivering reliable returns with stable cash flow.
Factors That Affect ROI in Real Estate
The average yield on commercial property investments depends on various factors that investors must carefully balance, including loan repayments, interest rates, maintenance costs and broader economic conditions.
Mortgage
A commercial property investment journey is often hard to start with cash alone, leaving many investors to make a down payment and then receive the remainder through a loan. As such, the monthly repayments on the principal & interest amounts associated with the mortgage can be a significant ongoing expense.
Depending on the size of the loan, mortgage repayments will continually consume the income generated from the commercial property, impacting the rental yield in relation to its value.
Interest rates
Interest rates impact commercial property returns both with the initial purchase price and ongoing expenses.
The Reserve Bank of Australia uses interest rates to balance inflation, fluctuating the cost of borrowing money and by extension, lowering or raising commercial property prices. Moreover, if your mortgage is structured on a variable rate, your interest payments will vary as the months progress.
Investors reviewing how to value new options in Australia’s commercial real estate market should consider potential changes in interest rates to ensure a continued net yield above the average yield on a commercial property.
Maintenance costs
Commercial investment properties must hold a range of modern utilities and amenities to enable uninterrupted business operations for tenants. From electrical and plumbing systems to more significant renovations and remodelling, investors must also include maintenance costs in their calculations for ROI.
These costs vary depending on the type of property, its condition, and the level of upkeep you are willing to provide. To maximise your ROI and ensure an ongoing, positive cash flow, it is essential to consider these expenses carefully and budget accordingly.
ROI vs profit
With our focus surrounding the average yield on a commercial property and ROI, it can be easy to confuse such metrics with total profit. Remember, the profit generated (monthly expenses deducted from income) is a crucial element within the ROI and cap rate formula (see above).
Profit is also traditionally used to describe the remaining capital gains from sold properties. As an asset, a sale incurs capital gains or losses once subtracting the property’s original out-of-pocket expenses from the selling price. On the other hand, your current commercial property yields are a measurement to evaluate ongoing cash flow.
Try our rental yield calculator to get a full breakdown of your growth potential.
How do you calculate ROI?
The formula to determine ROI on commercial property returns is:
ROI = (Investment Gain – Investment Cost) / Cost of Investment
Try our free rental yield calculator tool
For example, say an investor purchases a commercial property worth $1,000,000 with a down payment of $200,000. Closing costs totalled $10,000, with further remodelling expenses at $50,000.
Total out-of-pocket expenses are therefore $260,000 ($200,000 + $10,000 + $50,000).
Monthly expenses are principal & interest payments on the mortgage of $4,500 and an additional $2,000 to cover insurance, taxes and other miscellaneous expenses.
Total monthly payments are therefore $6,500 ($4,500 + $2,000).
Finally, earnings are $10,000 per month in rental income.
To calculate ROI, the formula would be:
ROI = [($10,000 x 12 months) – ($6,500 x 12 months)] / $260,000
ROI = ($120,000 – $78,000) / $260,000
ROI = 0.1615 or 16.15%
Ways to Improve ROI on Commercial Real Estate
From optimising rental increments and minimising vacancies to streamlining overhead costs and improving amenities, wise investors can employ various strategies to improve their commercial property returns.
Rental increments
Striking the right balance between rental rates to attract tenants and promoting healthy commercial property returns can be challenging. Whilst offering incentives, such as discounted periods, might be tempting to overcome the competition of other properties on the market, this can prove counterproductive. Inflation, taxes, rising utility costs and other macroeconomic fundamentals will erode your ROI if rental rates remain low or stagnant.
It helps to have a firm understanding of the broader real estate market and the average yield on similar commercial properties to help you set your rental rates at the appropriate levels.
Avoid vacancies
Without tenants submitting regular instalments of rental income, property owners are actively losing money, given the range of monthly expenses that still exist, such as loan repayments and maintenance costs. As such, a simple method to improve current commercial property yields is to minimise vacancy periods.
Doing so requires efforts to prolong tenancies and refine marketing campaigns to shorten transitionary periods. For example, it helps to maintain ongoing communication with tenants to understand whether they will continue their tenancy once a lease expires. If they are due to vacate, property owners can swiftly put in place advertisements to find suitable replacement tenants without any downtime.
Minimise overhead costs
Minimising overhead costs can also help improve ROI on commercial properties by reducing the amount of money you have to spend each period on areas like repairs, maintenance, and utility bills
Excellent methods for reducing overheads include:
- Refinancing your mortgage to take advantage of lower interest rates
- Shopping around for property maintenance & management services offering the best rates, without sacrificing quality
- Shifting between utility providers or even negotiating with tenants to cover utility expenses within their rental payments
- Introducing energy-efficient building practices and technology, helping to save on your monthly utility bills
Make improvements as necessary
Commercial real estate can rapidly lose value when falling into various forms of obsolescence. Whether it be physical wear and tear, outdated components and design flaws, or a decline in the surrounding geographical area, making improvements to keep your site competitive is crucial in improving your current commercial property yields.
For example, installing modern features like state-of-the-art security systems or updating fixtures and appliances as needed can lead to capital growth and ensure your property stays attractive to potential tenants. Even expanding onto unused land could work to accommodate tenants with larger operational demands, creating an opportunity for rental growth.
Read more about ways to add value to an investment property.
