Investing in commercial property can provide diversity, increased yields, and cashflow to a property portfolio. Private investors have historically been deterred from the asset class due to high cost of entry compared to a residential investment. However, with the price escalation of the residential market and subsequent compression of yields, savvy investors are beginning to seek out the better yields on offer through commercial property.
According to AMP Capital, commercial property can provide several benefits, “such as an attractive risk-return profile and low correlation with other asset classes (diversification) whilst also providing long-term inflation protection”.
Below is a list of elements that an investor must consider for a strategic commercial investment:
The Differences in a Commercial Lease
Lease terms can be much longer and more attractive than residential leases due to the quality of corporate tenants and their company backing. Leases can often be 3, 5 or 10 years with an option to renew. Leases may include mandatory annual increases which can ratchet the value of the property up over time.
Another benefit of commercial property is that the tenant usually pays all outgoings such as council rates. This can result in much higher net yields than residential, where the owners have to pay expenses such as rates, insurance and management fees. These can reduce the yield and quickly erode the cashflow on the investment.
When leasing, beware that certain tenancies may require council approval. Some tenants may negotiate a free-rent period, or ask for the lease to be subject to local council granting development approval. Commercial landlords may accept bank guarantee, where residential properties will only accept cash bonds.
Commercial Property Loans
Commercial lending generally has lower loan-to-value ratio (LVR) than residential finance. This means the investor will need a larger deposit, usually 30-40% of the value of the property (as opposed to 20% with residential property). Lease terms and length can also affect the banks’ appetite to lend on certain commercial properties, as well as affecting their valuations.
The commercial loan process is generally longer than the residential loan process due primarily to the additional complexities involved with commercial property investment.
Commercial loan terms are generally shorter (5 – 15 years) than residential (30 years), and depending on the lender and loan amount. Lenders may also require ongoing reviews (usually yearly), in order to determine the investors’ ability to continue to cover the ongoing repayments.
Interest and fees can be slightly higher depending on security, type of property and loan term.
Commercial Property Market Trends
Capital city markets traditionally sell on lower yields due to low vacancy and risk. Regional markets can offer higher yields but also may be more volatile due to lack of economic fundamentals in these towns. Some of the larger regional centres offer a good mix of high yield and lower risk. It is important for the investor to target markets in line with their budget, risk profile and yield requirements.
According to AMP Capital “redevelopment and targeting exposure to growth sectors such as technology and e-commerce will be critical to achieving outperformance in rental growth”.
Historically, direct real estate investment has produced relatively strong returns and low risk/volatility (see figure below).
Past performance is not a reliable indicator of future performance.
Source: MSCI AMP Capital Real Estate Research. As at December 2017.
In comparison to other asset classes, a high proportion of returns are being generated by income rather than capital appreciation. As mentioned above, commercial real estate lease term agreements are long-term in nature. These long-term lease agreements provide a relatively stable income stream to investors, helping to generate a stable return pattern and reduce total return volatility – according to AMP’s report.
Commercial Property Types
There are various types of commercial property such as warehouses, industrial complexes, office space, retail and restaurants. It is important to understand the macro and micro environment in which the property is located and make sure there is enough demand for the specific property type in the event the tenant vacates.
Commercial Property Management
Commercial properties are managed by commercial agents. These specialised agents are very pro-active at searching for the right tenant, as well as negotiating rent-free periods or other incentives to secure a long lease. Commercial property leases can be more complex than a residential lease and therefore requiring specialist advice from a solicitor. It will pay to have a solicitor with experience in this area rather than a conveyancer that may be more suited to a more straight-forward residential purchase only.
As with any investment, it is important to have a team of advisors to help you source, secure and support the asset. This team can include a solicitor, accountant, buyer’s agent, mortgage brokers and financial planners.
The team at Sound Property combine detailed industry knowledge with a national network of commercial agents, advisors and other corporate contacts to help clients achieve strong returns with minimised risk. Whether you are looking for a single or multi-tenant premise, a building with add-value potential or a just a high yielding investment, Sound Property can assist securing your next commercial investment.
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This article is provided for general information only and does not constitute personal advice, as it does not take into consideration your personal circumstances. Please consult a licensed tax or financial advisor before making any decision to invest.