How to Invest in a Commercial Property
What is commercial property?
Commercial property can be defined as any property other than property used for residential purposes. Therefore it includes shopping centres and malls, strip retail stores, farms, tourism assets, offices, factories, some sporting facilities and medical and dental surgeries.
By defining commercial property as “any property other than property used for residential purposes” we emphasise purpose over form.
Commercial property, in its various forms, has generally been a very good investment and will probably continue to be a very good investment.
Property and risk minimisation
Property tends to have much less price volatility than other classes of investment. This means that property has the effect of stabilising an investment portfolio and hence reducing the risk in it.
Returns from commercial property
Returns from commercial property comprise rents and capital gains (or losses).
Commercial property rents are generally high relative to residential property rents. Capital gains tend to be less than for residential property. Exceptions can occur, as can losses, but generally the capital gain is determined largely by the inflation rate, since this tends to determine rent increases. If a property’s annual rent increases by 3% then, all things being equal, one would expect its value to increase by 3% too. But things are rarely equal, and this will be reflected in the change on yield. As indicated above, value is an inverse function of yield, so falling yields mean higher values and rising yields mean lower values.
Yields are determined by a number of factors, some apply to the general economy, some apply to the property’s location, some apply to the type of property and others apply to the particular property. The factors include:
- General economic conditions. Favourable GDP forecasts normally mean that businesses will need space;
- Local geographic/demographic conditions. For example, the new ring road in Melbourne has led to higher values in the surrounding suburbs, due to their increased accessibility, and the expansion of a shopping mall will lead to lower values in local retail strip shopping facilities; and
- Matters relating to the property itself, including the length of the lease, the timing of rent reviews, whether the lease allows for automatic increases, and the financial strength of the tenant.
Whats the reason to invest directly in commercial property?
Clients should invest in commercial property because it is an asset class that generates high returns with relatively low risk. This risk can be diversified down by investing in a mix of commercial properties, whether by owning multiple properties or by owning indirect property, through listed property trusts, certain managed funds and property syndicates.
If commercial property comes second to residential property, then why own any commercial property? Why not only own residential property?
Yields - your income from the asset
One reason is that commercial property usually generates higher income yields than residential property.
- Rental yields of 7% or more are not unusual, and rental yields of 10% are encountered as well, whereas residential property yields are normally closer to 3% (with occasional exceptions in less popular areas). And with commercial property the tenant pays the outgoings (rates, repairs etc), not the owner, so there are lower cash outgoings as well.
- Higher yields and lower outgoings mean cash flow positivity even with high levels of gearing. That is more cash comes in than goes out, even before the tax advantages are considered. Many geared commercial properties don’t just cover the interest on the loan but they also cover the principal repayments as well.
Positive Cash Flow
This compares very well to residential property, where the cash flow effect is usually negative. One month after the client settles the purchase of a residential investment property, cash flow is down compared to what it was before; whereas one month after the settlement of an industrial property, cash flow is up compared to what it was before.
Commercial property usually has much longer leases than the residential property. Lease terms of five years, with options for a further five or ten years at the end are common. This creates more security than residential property, where terms are usually for no more than a year. Most residential property tenants see themselves as renting short term, whereas a business in a well located retail strip, or a manufacturing plant with specific features, will want to secure their own goodwill by obtaining security of tenure. This means they want the certainty attached to a long term lease.
Diversification from residential property to commercial property makes particular sense when the cash flow positivity of commercial property is considered: this positivity creates a cash flow buffer that takes away some of the stress of residential property prices falling.
Often we suggest clients build up a portfolio of two or three residential properties, plus their own home, and then diversify into commercial property. Another residential property may have created too much strain on the practice’s cash flow, whereas a commercial property instead adds to cash flow and alleviates some of the strain caused by the existing residential properties.
A client bought a factory in Moorabbin Victoria for $2,000,000 including stamp duty and other transaction costs. It is leased at $160,000 or 8% yield for the next five years. The tenant pays all outgoings including land tax (on a single holdings basis). The tenant is stable and has operated from the site for more than 20 years.
The bank lent the client 70% of the total cost of the property and the client contributed a further $600,000. The interest rate is 7.0% pa. The term of the loan is ten years.
The maths look like this:
- Rent: $160,000
- Less interest: (i.e. $1,400,000 times 7%) $98,000
- Net rents: $92,000
The net rent of $92,000 represents a return of about 15% on the client’s $600,000 equity. If an unrealised capital gain arises each year of, say, 3% (ie. about the inflation rate) then this generates a further 10% return, taking the total return on the client’s investment to about 25% pa.
Of this 25% return, 10%, i.e. the unrealised capital gain, is not taxed, and about 3% is sheltered from tax by large depreciation claims and similar items. This makes the investment very tax effective.
The investment is cash flow positive. This means it generates more cash than it costs to hold it. This excess cash is paid back to the bank, and the debt will be eliminated in about 8 years’ time. In fact the investment is so cash flow positive that it is also repaying all the principal due on the loan.
The big risk is that something will happen to the tenant, or that for some reason the tenant will not renew the lease at the end of the current lease. This means a big part of the due diligence is finding out about the tenant and forming a view of the “lettability” of the property if for any reason it became vacant.
A valuer’s report gave comfort here, indicating that historically the Moorabbin area had experienced only a 4% vacancy rates, and the vacant properties tended to be the lower quality older properties. Local real estate agents confirmed this view.
HOW WE SUPPORT CLIENTS
At Aspiire Financial Group, we assist clients with:
- SMSF lending
- Commercial lending
- Home Loans
- Investment Loans
- Debt Consolidation
- Commercial Loans
- Rapid Debt Reduction strategies