How do you make the step from investing in residential property to investing in commercial property?
Most people know at least a little bit about residential property.
Whether we rent or own our home, we’re familiar with the dynamics of the market.
Commercial property, on the other hand, is quite foreign to most people – we might work in an office, factory or shop, but we don’t have anything to do with the renting or owning of the building so we’re not ‘au fait’ with how it all works.
As with all investing, the first thing an investor considering making the move from residential to commercial property should do is become educated.
“Read some books on the subject, talk with existing commercial real estate investors, join the local property investors association, read commercial listings, look at some properties, talk with some tenants and start to understand how commercial property works,” says investor and author Dolf de Roos.
By doing this, he says, you should know if commercial property is right for you.
Unlike residential property, Colliers International national director of research Nerida Conisbee points out that commercial property is a very broad category.
Office, retail and industrial make up the bulk of it, but sectors such as self-storage, childcare centres, pubs, aged care facilities and hotels also came under the ‘commercial property’ umbrella.
There are many different ways you can invest in commercial property, according to Conisbee.
Specifically, you can invest in direct property or indirect property.
This can be that you personally own the commercial property or you have a share in the ownership and the shared ownership can be through syndicates or unit trusts.
Conisbee says the value at which most private investors invest ranges between $1 million and $10 million.
For direct ownership for individuals, she says the most popular price range is between $1 million and $3 million and the most popular assets are freehold property, even though owning part of a building, such as a strata office suite, seems to have a higher average rental return.
“It can be purely retail or office, or a mix of retail, office and residential,” she says.
Wakelin Property Advisory managing director Monique Sasson Wakelin points out that investors should be looking for high-grade investment quality assets and the entry level for that is around $1 million.
Conisbee points out, however, that if investors want to get into a larger, better quality building it will cost between $5 million and $10 million.
One of the main attractions of a syndicate is that they’re able to buy more expensive property and at those higher price points – i.e. $10 million to $15 million – there’s much less competition for assets, says Conisbee, and better returns.
She explains that at their simplest level, a syndicate involves two investors owning property, but it can be any number of people or companies owning a particular asset.
Meanwhile, Conisbee explains that with unit trusts a property is basically divided into shares (called units), but the key difference between unit trusts and investment trusts is that the former isn’t listed on the stock exchange.
The money is invested when the property is purchased and although units can be sold at any time, more units aren’t generated, which is another difference between unit and investment trusts.
Investing in indirect property is another way to invest in commercial property, explains Conisbee, through listed property trusts (Australian Real Estate Investment Trusts [REITs]) or unlisted property trusts.
“It’s most easily explained by the purchasing of shares in companies that specialise in property.
By buying these shares it’s possible to achieve financial returns in line with those of the property market without requiring large quantities of capital generally required for direct property.”
One of the benefits is that it’s possible to achieve a high degree of liquidity, which you don’t have with direct property.
WHAT ARE SOME OF THE DIFFERENCES BETWEEN RESIDENTAIL AND COMMERCIAL PROPERTY?
The big advantage about investing in commercial property now, says Conisbee, is that residential price growth has flattened, but while the commercial property market experienced quite a significant downturn during the global financial crisis, it’s now heading into an upswing.
Dolf de Roos is a self-proclaimed “big fan” of residential property, but he believes the advantages of investing in commercial property are so great that once people understand it they’ll see that it’s far easier and more lucrative than residential property.
He says the benefits of investing in commercial property over residential include:
- Commercial leases are longer than residential tenancies. Residential leases are usually for a year or less, while a commercial lease can be for two or three to five years or longer and then there are usually options of another three to five years at the end of that time to renew the lease. Most commercial leases also have provisions for regular rent reviews, where rents are adjusted to market levels. Most leases have a ‘ratchet clause’, so rents can go up at a rent review, but not down.
- Under the terms of a commercial lease, there can be an Assignment of Lease, which might occur if a tenant sells his business. The Assignment of Lease is a contract between the seller, the buyer and the landlord. It references the original lease, gives the landlord’s consent to the buyer taking over the position of the seller and holds the seller liable if the buyer defaults. In other words, if the new tenant is in default of their rent, you can go back to the original tenant and collect the rent from them. That’s unheard of in residential property.
- With a residential property, the tenants pay only the rent and the landlord is left to pay the rates, insurance and maintenance. With a commercial lease, it’s common for tenants to pay the rent and all the outgoings.
- Almost without exception, if any major improvements are going to be made to a residential property, the landlord will pay for them. In many commercial leases, there’s a clause stipulating that if the tenant requests major improvements to be made, and if the landlord agrees to make and pay for those improvements, then the tenant shall pay a proportion of the cost of the improvements as extra rent.
- Tenants generally earn their income on the premises and therefore have a vested interest in keeping the place looking good. Very often, commercial tenants will paint the premises or make other arrangements. When something stops working, unlike residential tenants who are quick to call the landlord, commercial tenants tend to fix it themselves, partially because most leases stipulate that the premises must be maintained in the same condition they were at when the lease began and partially because they just want if fixed right away so they can get on with their business.
Commercial property will generally give an investor better returns than residential property.
With residential property, you probably get 3.5 per cent or a four per cent gross yield but you pay the outgoings, so it comes to about three or 3.5 per cent return, whereas with commercial property the smallest return is 6.5 per cent and could go up to eight per cent and generally the tenant pays the outgoings.
In residential real estate, you have the choice of managing a property yourself or using a property manager and it’s no different with commercial property.
But de Roos believes the effort to manage a well maintained commercial building is almost negligible, because so much is stipulated and agreed upon in the lease.
IS IT RISKIER?
Many people believe commercial property is a more risky investment than residential property because the market can be more reactive to economic ups and downs.
But de Roos says the opposite holds true.
“When the economy turns down, residential tenant may leave straight away or demand a reduction in rent,” he says. “Since commercial tenants are tied into a long-term lease arrangement, usually with a ratchet clause, often the economic downturn is over before the lease expires.
“Also, if tenants rent both their home and their commercial premises, they’ll often prefer to downgrade their residence before considering downgrading the source of their income.”
However, some experts contend that you can generally find a tenant for residential property, even if you have to drop your asking rent, but sometimes commercial properties can be vacant for long periods of time.
Requirements for commercial properties vary from tenant to tenant but each residential property has all that’s required for someone to live in it.
Conisbee doesn’t believe commercial property is more risky than residential, as long as you’re investing for the long term.
She believes that in the $1 million to $3 million price point commercial property acts similarly to residential in terms of the number of purchasers available and the purchaser profile.
In the $150 million to $200 million bracket, however, she says something like the global financial crisis can have a big impact.
“I think long-term capital growth is assured, particularly in a strong market like the CBD and metro office markets, but in the short term the dynamics are different. You don’t have that same dynamic occurring in residential.”
THE FINANCIAL SIDE OF THINGS
The entry level for good commercial property is higher than in the residential sector, according to Wakelin.
She believes in today’s market one needs to be looking at investing at least $1 million to access quality commercial property, which may be restrictive for mum and dad investors.
But de Roos says you don’t need to have millions of dollars to invest in commercial property.
He points out that his smallest commercial property – a corner fish supply shop – cost $59,000 and had Alease generating $10,400 per year for a 17.3 per cent return.
Lang notes that you can buy office suites for the same price as a residential unit in one of Australia’s capital cities.
Investors interested in making the move from residential to commercial should also bear in mind that equity from a residential portfolio can be used to leverage into commercial investment property.
Aside from acquisition costs, the costs of a commercial property are pretty much on par with a residential investment, says Conisbee.
There’s stamp duty, agent’s fee, valuation and legal costs, but she does point out that due diligence can be more time consuming, which means it can cost more.
The catch with commercial, though, is that when it comes to borrowing money you’ll need a greater deposit than residential property, with lenders’ loan-to-value ratios (LVR) typically being lower for this property type.
Generally speaking, says de Roos, banks are willing to lend a smaller proportion of the value of a commercial property than of a residential property.
“Banks typically have loan-to-value limits of 50 or 60 per cent and in some rare cases 70 per cent on commercial properties, whereas they’ll go much higher on residential properties,” he says.
Conisbee says LVRs for commercial property differ according to asset, lease and location.
For instance, she points out that 10-year government tenant with an office building would have a higher LVR than it was a vacant retail property in a secondary retail strip.
HOW COMMERCIAL IS VALUED
Residential and commercial property are valued differently, explains de Roos.
Residential is valued according to comparable sales in the area and whether you have a tenant or not is of little significance.
“Commercial properties, however are valued based on the revenue that they generate,” says de Roos.
“Generally, the value of a commercial building is a multiple of the rent it generates. In real estate terms, the value is the rent divided by the cap rate, which is the market average return of similar buildings in similar areas.
“So, the more revenue a property generates the more that property is worth.”
Wakelin reiterates that one of the key differences between residential and commercial is that the latter is driven by yield.
So, the lease and how well it binds the tenant to the property, and to an extent the success of the tenant’s business, are important.
“Commercial property values are a function of economic and market conditions, net yield, the track record of a property, the quality of the tenants and the nature of the lease that binds those tenants,” she says.
While the yield is generally better for commercial property than residential property, investors can also expect to get capital growth from the former.
The two are tied together though, with yields having a big impact on the value of a property.
SO, WHAT TO BUY?
After doing thorough planning and seeking professional advice about investing in commercial property, Wakelin says you then need to ask yourself: ‘Why do I want to buy commercial property in the first place?’
If you’re an owner-occupier buying to buying to house your business in a property your decision making will be subjective because it’s specific to your business – you’ll want it to be close to suppliers and customers and easily accessible for employees, plus the premises will have to feel ‘right’ to you.
For an investor who’s buying to make money, however, the criteria is very different.
The decision making is unemotional and rational and objective, all of which are absolutely critical to maximise returns.
Once you’ve worked out why you want to buy a commercial property then you should consider the location and the type of property to buy.
One product type isn’t necessarily better than another – they’re simply different, says de Roos.
“Your decision will depend on any number of factors including personal preference, the best ‘fit’ for your objectives, current market conditions, risk aversion, skill set, experience and perhaps most importantly, which deal happens to come up on your radar.
Conisbee suggests investors do their research into where each market sector is sitting at the time you’re looking at buying.
Look at things like what’s selling and what’s leasing, what rents are being achieved and what the rental outlook is.
At the moment, she says the office market is firmly in upswing mode across Australia, while varies according to take off and retail varies according to location.
Once you get to the asset level then you need to understand the asset, Conisbee explains.
Due to the costs of buying and selling, you need to take a long-term view, and consequently, understanding the type of tenant you’ve got in the building is really important.
For instance, if it’s a good tenant with a lease term of 10 years then you’ve got 10 years of guaranteed returns on the asset, but if there’s only one year left then it’s far more risky.
She says sustainability is also an important consideration, particularly for office; it can be difficult to attract tenants (especially government tenants) for buildings that have a low energy rating.
There are certain fundamentals investors look for in residential real estate such as location, proximity to amenities and transport and development potential.
But are they the same for commercial property?
Well, de Roos says yes; “many of the same fundamentals hold true for commercial real estate”.
Conisbee points out that you want to make sure the property is in an area that’s attractive to tenants and their clients, so you need to be close to public transport and amenities and make sure there’s enough parking.
“Since the value of a commercial property is so intimately related to its ability to generate rental income, the main factor to consider is: will this property be able to attract tenants moving forward?” says de Roos.
This article was written by Vanessa De Groot and originally published in Australian Property Investor Magazine and has been republished with their permission.
SUBSCRIBE & DON'T MISS A SINGLE EPISODE OF MICHAEL YARDNEY'S PODCAST
Hear Michael & a select panel of guest experts discuss property investment, success & money related topics. Subscribe now, whether you're on an Apple or Android handset.
PREFER TO SUBSCRIBE VIA EMAIL?
Join Michael Yardney's inner circle of daily subscribers and get into the head of Australia's best property investment advisor and a wide team of leading property researchers and commentators.