A beginner’s guide to commercial investing A Beginner’s Guide to Commercial Investing Why choose commercial property? In short, commercial property offers the highest cash-flow you will find in Australian real-estate. In this post COVID climate in Australia – where interest rates are at an all-time low and high-quality commercial property is scarce – this tightening of the market has resulted in yield compression for commercial property (which is effectively capital growth), with returns currently far outweighing what residential property can deliver. Exceptionally high yields, the option to negotiate long leases (some commercial properties boast three, five and upwards of ten year leases) and the opportunity to build annual rental increases into the contract make commercial property an incredibly appealing investment for many. But the most significant reason why you should choose commercial property must be the tenants. Apart from them being responsible for all outgoings, a well known branded tenant, for example, Coles, Australian Post, BWS, IGA or Suncorp, have their reputations to uphold and will guarantee security and therefore strong returns. The option is clear, when at the other end of the spectrum lie residential tenants who can be far more unpredictable, leading to many unforeseen costs for a landlord. Commercial tenants are of course not perfect, but when you purchase a high-quality commercial asset, it’s likely those tenants will far exceed anything you would have known in the residential world. Your reward will be a secure, long term investment which produces a high-cash-flow and after you’ve paid your loan in full (some commercial can be paid off in as little as ten years time), a passive income straight into your pocket. The basics of commercial property investing What is commercial property? Commercial property is real estate used specifically by investors for purposes intended to generate a profit. In Australia, it usually takes the form of building, within the four asset types (office space, retail, industrial or specialty), however, there are many other sub categories like medical, hotels, short term accommodation, etc. The four main types of commercial property Commercial property can be divided into four distinct asset classes. Office space, retail, industrial and specialty. Each asset type has its own set of risks and rewards, and follow trends. It’s important to understand the fundamentals of each and their relationship to the current market to make sure you are purchasing a winning commercial asset. Let’s take a closer look at them individually. Office Space Commercial office space could be anything from a multi-level office tower in a central business district to a small office in a suburban area. When investing in office space it’s important to factor in; Employment growth, business confidence and, post COVID, workplace flexibility changes as the key drivers in the office space market. A high-quality office asset will be: – Located close to food and retail amenities – Close to transport networks or have ample parking available for employees – Set in pleasing surroundings and boast plenty of natural light – A well maintained building (saving the costs of repairs since tenants pay for these themselves) – Close to other similar businesses Retail Retail space could be anything from an entire shopping centre, for instance a Westfields, all the way down to a 50m2 hairdresser shop front. Key drivers in the retail markets are, consumer confidence, interest rates, time of the year (Xmas boom period), tenancy mix of the area and income growth. Investor demand is influenced by low interest rates, a strong housing market and general health of the economy. A high-quality retail asset will be: – Highly visible from a main road with access to ample parking if a strip shop or in full view if inside a mall. – Close to quality anchor tenants (also known as key operators), and if situated in a mall, one with low vacancy rates – Positioned in affluent areas as wealthy people have more disposable income. – Located in an area with a growing population – Boasting well-established tenants who are likely to renew their leases (with long-lease and strong covenants in place) – Offering zoning options, multi-tenant uses, or the potential for future development of the property Tip: When considering a retail property it’s important to complete a competitor analysis on the area. For example if you are looking at a supermarket, research all of the other supermarkets within a 5km radius of that property. Are any new supermarkets being built? How much turnover does the supermarket currently make per week? Are the other supermarkets in the area doing better or worse than the one you’re considering? These are just some of the questions you need to ask. Industrial Industrial space could be anything from a small 100m2 industrial site, with a flexible interior space (a mix of office and warehouse space). To a major logistics hub which could be over 100,000m2. For example, an Amazon warehouse. Warehouses or factories are used to produce or store goods), or the largest size, which are often used as distribution or logistics centres. Prime considerations are strong road networks (freeways and motorways), which provide access to metropolitan areas and proximity to ports and cargo docks. Key drivers of industrial commercial property are a strong economy, great access to important infrastructure and the interest rate environment . A high-quality industrial asset will: – Be in close proximity to food retailers and other desirable amenities within population centres – Boast a well-maintained, secure building with office space, kitchen, toilets and air-conditioning – Feature an external loading dock with heavy-vehicle accessibility and suitable height-limits – Have minimal restrictions (if any), on water usage and discharge or noise, along with no major environmental concerns – Flexibility to add offices or showrooms to the premises – Boast high ceilings as many tenants use stacking shelves for storage Tip: Typically industrial assets are less volatile than other commercial property markets, with rents and occupancy levels experience slow and steady increases during periods of economic expansion and slight declines during recessions but in general the industrial market is less volatile than other commercial property markets. Specialty Specialty commercial property could be anything from a service station, a childcare centre, to a hotel or pub. Key drivers of specialty commercial property are business confidence for that particular sector, interest rates and the general strength of the economy. A high-quality specialty asset will: – Be scarce to find i.e. if you are buying a childcare centre and there are three more under construction in the same suburb it might be too risky – Have a strong lease backed by a secure tenant Tip: When it comes to specialty assets it can take a lot more specialist knowledge about the asset class to succeed. For example, if you are looking to buy a service station you’ll need an intimate knowledge of the petroleum industry before purchasing. The lease agreements for these assets are also more complex as they incorporate things like fuel line maintenance to environment protection agreements. What to look for in a high-grade commercial investment Location Location is vital for commercial property. It could make or break a business. And depending on the asset class, you will need to satisfy different criteria each time, (see ‘The Four Types of Commercial property’). Vacancy Vacancy can be used as a barometer of what’s going in the area. A lot of vacant shops, warehouses and office buildings indicate that it might be difficult to secure another tenant should you lose yours. Building Pursue a well-maintained, modern building with a nice aesthetic exterior and interior, where minimum upkeep is required. Tenant A property’s value is often closely tied to the strength of its lease. A tenant who has occupied the premises with their business for many years is highly desirable. It’s a good sign that business is good, but also means that they are unlikely to move if they’ve built up a certain amount of goodwill with their clients or customers, for instance, a returning client base (dental surgery, veterinarian or beauty salon). Property fitouts can also run into the hundreds of thousands of dollars and such investments will mean tenants will be reluctant to leave even if they find cheaper rent down the road. It’s in their vested interest to stay long-term. But don’t forget commercial properties are still available even when vacant. The reason? There’s an owner occupier market just like there is with residential. Many businesses choose to buy the property they occupy and so when they decide to sell, the building goes to market again. Value-adds and ways to increase your investment Buying under market value immediately increases the value of your property as it is already worth more than the purchase price. Some tenants occupying industrial assets build mezzanines as a way to create more space, or 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 until approved by council. Do your research here as there may be an opportunity to secure the property for cheaper and then retrospectively approve the add-on through council, equalling an instant increase in the property’s value. Adding more square meterage to the property or dividing-up space can add significant value to your commercial property. Adding highly desirable assets such as storage or parking to your commercial property are both great options as both are highly sought after by tenants Increasing rents can have a huge effect on the 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. What a good commercial buyers agent will do on your behalf (step-by-step process): Research the tenant and undertake due-diligence. The first step is to find out all about the tenant and their business, past and present. How long have they been at the premises? They will deem to establish if the tenant has paid their rent on time, and that they’re paid up to date and request an arrears report. Remember, that in commercial property the building is worth nothing without the tenant, so make certain that you purchase a property which will attract high-quality tenants and that any current tenants are fully vetted before making a purchase. Have an understanding of the different asset classes. Where each asset class is in its cycle and what will still be a solid investment in ten years time. Depending on what your personal criteria are as the client (i.e buying in a capital city, high-cash flow or diversification within your portfolio), a good buyers agent will understand which type of commercial asset would best suit your needs. Have an understanding of the locations you’d like to buy in. It’s imperative that your buyers agent knows the market value of the areas you’re interested in, including what similar properties in the area lease and sell for, if there are any upcoming infrastructure plans and the population demographic. Source the properties on your behalf. Note – Buyer’s agents with more experience tend to have larger networks, delivering their clients more off-market properties. Off-market properties are extremely valuable to you as it means less competition. Negotiate the terms of the contract on your behalf. Support you through the whole sales process. Link you up with the best rental managers in that area. Long term support. After settlement they will continue to support you with your property. Pros compared to residential Pay your investment off faster and start generating a passive income. High-quality commercial property has the potential to pay itself off in ten years, compared to the traditional 30 years a residential property might take. That means all of that money usually going to the bank, after the debt is paid, then goes straight into your pocket. Higher Yields. Commercial property has traditionally offered higher yields compared with their residential counterparts, and with the tightening of the commercial market, along with commercial becoming more mainstream and interest rates at an all time low, we are seeing yields in commercial property that we just cannot access through residential. In the post COVID climate we are seeing yields upwards of 6-9% in commercial properties. Negotiable lease terms. Because contracts with tenants are incredibly fluid, if you know what you’re doing you can use this to your advantage and secure a great deal. Tenant Pays Outgoings. Unlike residential property where the landlord often pays for water usage in apartments, council rates or repairs and maintenance to the premises, most commercial tenants sign what are called ‘net’ leases which require them to pay (most of the time), all outgoings. Longer Leases. Commercial leases can span anywhere from 3 years (it’s usually the minimum), to as long as 15. Well looked after property. Tenants have a vested interest in the property, because it’s their livelihood, which means they are more likely to look after it. Annual rent increases. Most commercial property contracts have annual rent increases built in which are fixed, often of around 3-4%, or linked to CPI. Diversification. Holding both commercial and residential properties in your portfolio place you in the best position should either of these markets take a fall. Depreciation.Commercial investors have the opportunity to claim thousands of dollars in depreciation. Variety of ownership structures. You can purchase it 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. Higher quality tenant. As mentioned above you are often dealing with businesses that have a reputation to uphold. This means they will look after the property to maintain their branding presence, they also will pay their rent on time as it’s not a good look to the public if a large company doesn’t pay their rent accordingly. Cons compared to residential Higher deposits needed. The maximum loan you would usually receive when buying commercial property would be 60-70% (some banks are offering 80% loans), unlike the 90-95% now available for residential property. This is because commercial property is deemed more risky and their loan value ratio (LVR is lower). Residential property can be purchased with as little as $50,000 as a deposit to cover all necessary costs. Commercial on the other hand is $75,000-$100,000 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 can be up for negotiation and you will need a seasoned lawyer and negotiator in your corner to make sure you understand what you are signing up for. Sensitive to economic conditions. Commercial property is directly linked to what’s happening in the economy. For instance during COVID we’ve seen a decline in demand for certain office assets and some retail assets. This has been due to people working from home and also shopping more online. However, where 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 retail supermarkets in suburban areas have done incredibly well as people are staying close to home. Reduced capital growth. Capital growth 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. This coupled with commercial property having increased exposure to economic cycles, and, managing the end of a lease – where you may be required to make repairs or undertake maintenance – all mean that you need to be prepared for longer vacancies. Harder to sell. Because commercial property is traditionally seen as riskier and it requires a deeper understanding of economics and business compared with residential. The best time to sell is at the beginning of a lease, with a tenant who is doing well. Key terms you should know ‘Yield’ – Is a percentage term describing the income generated from an investment ‘Gross Yield’ – Describes the rate of return a property generates and is calculated as the rental amount paid by the tenant and divided by the property value. ‘Due diligence’ – Investigating a potential investment or purchase to confirm all material facts. When someone is preparing to purchase a property, there are many different aspects of due diligence involved. The buyer needs to examine, among other things, the contract of sale, and the planning controls in place that will affect how the land and/or buildings are used. ‘Net Yield’ – Is the same calculation but after all outgoings and expenses are taken into account ‘Capital Gains’ – An increase in the capital asset’s value ‘Capital Gains Tax’ – Is the tax that you pay on a capital gain ‘Fit-out’ – Preparing a leased space for occupation by the tenant and may include the installation of things like floor coverings, partitions and signage. Fit-outs are usually a tenant’s expense (but this can sometimes be negotiated). ‘Yield Compression’ – Is the reduction of implicit yield paid for the property ‘Net Operating Income (NOI)’ – Is the calculation used to analyze the profitability of an income-generating real estate investment. Property revenue minus all reasonably necessary operating expenses. ‘Loan Value Ratio (LVR)’ – Is the amount you need to borrow to purchase a property ‘WALE’ – This term is typically used on any commercial investment property with two or more tenants. ‘Anchor tenant’ – The main tenant in a leased commercial property who generally attracts other tenants and/or people to the property. ‘Covenant’ – A condition in a real property deed or title that limits or prevents someone from using a property for certain purposes. ‘Negative gearing’ – Borrowing money to buy an asset and receiving income (other than funds used to cover the loan interest and maintenance costs) from the investment. In Australia, the shortfall between income earned and interest due can be deducted from an individual’s tax liability. Negative gearing becomes profitable when the property is sold, assuming that property values are rising and a capital gain can be made. Investors considering negative gearing must have the finances to fund their ongoing interest and maintenance costs until the property is sold. ‘Consumer Price Index (CPI)’ – The average change over time in how much households pay for a fixed basket of goods and services. In Australia, the Australian Bureau of Statistics publishes CPI figures. The CPI can indicate changes in economic inflation and variations in the cost of living. ‘Depreciation’ – The reduction in value of a tangible asset over time. With respect to real estate, depreciation can also mean a drop in the value of property assets due to poor market conditions. ‘Gross Leasable Area (GLA)’ – The floor area that can be used by Tenants. Generally measured from the center of the joint partitions to outside wall surfaces. ‘Mortgage insurance’ – An insurance policy that the lender or borrower can purchase to protect themselves against mortgage default. In Australia, Lenders Mortgage Insurance (LMI) is usually required for mortgages greater than 80 per cent of the property value. In most cases, the borrower pays the insurance premium for LMI. ‘Sale and Leaseback’ – When a company sells their building to an investor and then signs a long-term lease for the space, providing income for the investor ‘Sublease’ – A lease or rental agreement between a tenant who already holds a lease to a commercial space or property and another party—called the sublessee or subtenant—who wants to use part or all of that space. 5 secrets to success in commercial real estate Build your relationships and keep them strong. One of the biggest points of difference between commercial real estate and residential real estate is that it is a relationship based business. Knowing this will put you one step ahead and help you secure the best deals, convince the seller to work with you instead of your competition and help you build rapport with brokers who send you their best off market deals. Purchase at the right time in the right industry. At any point in time different asset classes and sectors within these perform better or worse. For example, right now many office markets are performing worse than industrial. 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. Purchase an asset that can be easily re-let. If you are not confident in replacing the tenant in that worse case scenario, then it might not be the deal for you. Do your research. On both the tenant and the property to make sure you purchase a property with a rock solid income and the due-diligence is there to make sure the asset itself is all checking out vs 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 $120K. So that’s a 30% deposit, plus stamp duty, solicitor fees and your building and pest inspections. That figure is based on a $300K 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. Rethink Investing Commercial Property Checklist: Always check for competition. You wouldn’t purchase a pharmacy if there’s two more being leased out right around the corner. Check the vacancies in the area you are considering investing in. If there is a lot of nearby space vacant, 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 sqm 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 leasing managers to find out any market trends that might affect your property.