Beginner’s Guide To Investing In Commercial Properties
Category : What you need to know
Successful commercial property investment requires an understanding of the complex market factors at work, unique financing requirements, property management options, leasing arrangements and a good grasp of the potential risks.
An understanding of these factors will provide a reliable basis for the selection of commercial investment properties that will succeed, being either retail, industrial or office.
The following considerations apply equally to large and small commercial property and will help to identify suitable locations and opportunities for investment.
Understand the commercial property market drivers
The fundamental driver for commercial property growth is similar to the residential market – it’s demand. However, commercial demand is driven by economic factors as well as population growth.
A strong economy is fundamental for any successful commercial property investment. Booming commercial markets are supported by strong international, national and local economies.
As the economy starts to grow, transport companies experience the first signs of growth, driven by the increased demand for materials used in the manufacture of goods for sale, an increase in imported goods and/or an increase in building. Transport stocks begin to rise on the back of increased business and earnings, more jobs become available, and the demand for office space increases.
As the economy continues to grow, the demand will start for warehouse space, then retail, followed by office.
Other factors that influence commercial property demand are:
The Reserve Bank of Australia uses interest rates to manage inflation. Increasing interest rates helps slow growth; the cost of money is higher and the rate at which companies can grow is reduced. Additionally, increasing rates reduces consumer spending. This has a slowing effect on the demand for both commercial and residential property.
The development of infrastructure can increase the demand for commercial property. The opening of the M7 bypass around the western outskirts of Sydney led to an increased demand for warehouse property in the outer ring close to the M7 exits. Cheap land and access to good roads provides impetus for transport companies to move their warehousing facilities.
As different segments of the population are motivated to move to different locations, new opportunities arise. For example, the ‘sea change’ Baby
Boomers have increased demand for healthcare services, among others,
in coastal centres, and new suburbs with young families require greater childcare facilities.
As lifestyle becomes increasingly important, more people want to work nearer to home. Thus there has been an increase in the number of small offices located in lifestyle suburbs such as the northern beaches area of Sydney.
Locations that have strong population growth require many services. As new suburbs spring up, shopping centres are built to service the growing consumer demand. Grocery stores are required, then cafes and specialty shops, support services (small industrial), and then office space.
Consumer spending increases demand for product, so the requirements for warehousing and retail outlets increase.
Understand the risks
A well-researched commercial property investment can be very lucrative and require little attention for some time once it’s tenanted. However, awareness of the risks will enable the investor to be prepared for adverse circumstances.
Risks to be aware of:
- Lease terms
Long-term leases of 3–5 years or more can have advantages, but it takes longer to find a tenant if the property becomes vacant. Prolonged periods of vacancy are common and an investor will need to be able to handle the carrying costs during this period.
- Size of commercial property
Larger commercial properties can be harder to lease than small suites and will cost a lot more to hold.
Changes in supply conditions can create potential problems. An increase in new property coming onto the market in the same area creates a threat to existing tenancies as tenants may look to upgrade or expand. Strong supply can also reduce potential yields.
- Changes in infrastructure
Major infrastructure implementations or changes have both a beneficial and negative effect on commercial property returns. While infrastructure can attract commercial investment to an area, it has the negative effect of drawing tenants from existing areas. Keep in mind that areas close to CBDs are always popular. However, new growth areas further away tend to have more pronounced cycles.
Individuals, companies, syndicates of investors and trusts can purchase commercial properties. For individuals or groups of less than five, an ideal structure to use is a Self Managed Super Fund (SMSF), so long as no mortgage is required, ie, the fund can purchase a property outright. An SMSF can also provide investors with tax benefits.
Commercial property finance is often more complex than normal residential funding. Some financiers specialise in commercial property finance because of the complexity of some situations.
Normally banks will lend up to 70% of the value of the property but this value is often based on the rent/yields achieved by the property.
The management of commercial property is usually undertaken by commercial agents who operate more like ‘dealmakers’ than traditional residential agents.
The agent will try to match the property with an appropriate business and can lure businesses by arranging attractive deals, like rent-free periods, free fit-outs and the like.
The details in the lease can make or break a commercial investment.
- Leases can be three, five or even 10 years with an option to renew.
- Rental increases linked to CPI.
- The tenant pays all outgoings. This includes rates, water, body corporate fees, etc.
- The tenant makes good any physical changes (often the tenant will be allowed to install partitions etc, however, the owner reserves the right to have the office, shop or warehouse restored to its original condition). This enables the owner to rent to a suitable tenant when the existing tenant leaves.
- Some types of tenancies may require special council approval, for example chemical treatment facilities (such as those used by an electroplater), medical centres, childcare centres and so on.
Leases over a certain value are registered with the Department of Lands (NSW) or equivalent in each state.
Small new or ‘off-the-plan’ commercial suites or warehouses in high-demand areas provide a lower risk option for investors to enter the commercial property market. Entry prices range from about $250,000 and initial returns are often guaranteed for the first year. After this, regular yearly CPI increases help maintain reasonable yields.
Having the ability to let newly finished offices or warehouses adds to the attraction of this type of commercial investment.
However, this doesn’t negate the requirement or importance of understanding and managing the associated risks. This information will hold the investor in good stead as they move into larger commercial deals.