More and more sophisticated investors are considering commercial real estate as a viable investment strategy.
They have usually built a substantial asset base and are now looking for more cash flow in their investments.
Often, they buy smaller properties – such as a shop, strata office or perhaps an industrial warehouse – because the entry-level price for larger commercial premises is quite high.
Commercial property investment remains a sound strategy but, in my opinion, it shouldn’t be attempted without an expert team working with you.
Plus, commercial leases are very different to residential ones, they are more complex, usually prepared by a solicitor and run for 3 to 5 years.
Here are four things that you need to know about commercial leases.
1. Retail or not?
Many commercial leases are considered to be retail in nature (even if the premises are not a typical shop) because the tenant’s business is providing goods and services.
That means those leases are covered by their own legislation, the Retail Leases Act 2003 (Act), which can be a little tricky for the uninitiated to understand.
The Act imposes obligations on both parties but protects the tenant more if they are covered by the ACT.
For example, landlords can't pass on certain costs to tenants in a retail lease, things as legal costs for preparation of the lease, land tax (which can be substantial for commercial property), or costs relating to essential safety measures.
And owners must provide prospective retail tenants with a Disclosure Statement which outlines important information about the lease and the occupancy costs including outgoings.
2. Rent reviews
Retail lease rent increases generally happen every year and can be by a fixed rate, percentage increase, or commonly reflect the Consumer Price Index increase.
Then at the end of the lease, the rent is usually reviewed to the current market rent, if the tenant agrees to take up their option to release the premises.
If the tenant disagrees with the proposed market rental increase, it's a good idea to get an independent valuation to determine the revised rent.
3. Fit-out and make-good costs
Unlike residential leases where tenants are usually not allowed to make any changes to the property, retail leases are kind of the opposite.
While the fit-out generally has to be approved by the landlord and local council at the outset, it is the tenant’s responsibility to pay for this.
Perhaps, it is a clothing store that needs to have fitting rooms and a counter installed or it could be a café that needs to be renovated to attract customers.
The ability to fit out the premises should be included in the lease, but it is the tenant’s financial responsibility to do so.
Likewise, at the end of the lease, the tenant must pay for the premises to be restored to their original condition, which is called a make-good provision.
Of course, like all things in real estate, there is room for negotiation between the outgoing tenant and the landlord regarding this requirement.
Again, this is why commercial investors need expert advice and guidance before buying because leases are quite different from residential ones.
4. Additional costs
Another major difference between residential and retail leases is that the tenant is required to pay additional costs.
Whereas a residential tenant is required to pay rent, and perhaps excess water in some locations, a commercial tenant is also generally financially responsible for things like:
- council rates;
- water rates;
- insurance;
- owners corporation fees;
- air-conditioning maintenance costs;
- land tax (if a non-retail lease is in place);
- landlord’s legal costs (if a non-retail lease is in place);
- mortgagee’s consent (if a non-retail lease is in place);
- repairs;
- refurbishments; and
- make good at the end of the lease.
And the tenant often has to provide a bank guarantee or a larger security bond - often the equivalent of 3 or 6 months' rental - at the commencement of the lease
Of course, as a commercial property investor, that means there is less financial outlay for you, but it’s also important to remember that most small businesses fail within five years.
While periods of short-term vacancy are normal in residential real estate if your tenant’s business fails – or worse goes bankrupt – you could be left with a commercial premise that is vacant for months or even years if bought in the wrong location.
This is why, just like residential property investment, location is vital to ensure you are buying premises with the best chance of attracting and keeping, long-term tenants as well as the best chance of achieving solid capital growth.
Commercial property investment can be a successful strategy for more advanced investors, but you must know what you’re doing and, preferably, work with a team that can do the heavy research lifting for you.
