A beginners 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

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

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

7 steps to building
your $100K passive
income with commercial

A one-of-a-kind guide filled with concrete, practical and expert advice to maximise your wealth.

hi-res-book-cover 1

7 steps to
building your
$100K passive
income

A one-of-a-kind guide filled with practical and expert advice to maximise your wealth.

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 commercial investment

1. Buying under market value immediately increases the value of your property as it’s already worth more than the purchase price.

2. 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.

3. Adding more square meterage to the property or dividing-up space can add significant value to your commercial property.

4. 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.

5. Increasing rents can have a huge effect on the portfolio, as it increases cash flow and capital growth.

6. 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.

A step-by-step process of what a good commercial buyer’s agent will do on your behalf

1. 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.

2. 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.

3. 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.

4. 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.

5. Negotiate the terms of the contract on your behalf

6. Support you through the whole sales process

7. Link you up with the best rental managers in that area

8. Long term support.

After settlement they will continue to support you with your property.

Pros of commercial property 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 of commercial property 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.

5 secrets to success in commercial real estate

1. 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.

2. 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.

3. 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.

4. 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.

5. 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 $75K. That figure is based off a $300K property boasting 100 square feet (perhaps a small physiotherapist or office or warehouse located in a capital city).

These properties are good quality with smaller tenants and would still offer three year lease options, so they’re a great investment all round. As for finance options, some banks are offering 80% leases now. So that’s a $60K deposit, plus $10K for stamp duty, $3K for solicitor fees and around $500 for your building and pest inspections.

As you can see, once you add it all up, you can enter the market and start building your commercial property portfolio all for a relatively modest amount.

Rethink Investing’s 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.