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Tips and traps of investing in commercial property

Smaller-scale investors are looking beyond residential real estate. Should you?

Emma Sorensen

Your Money contributor

(iStock.com/sfe-co2)

Once considered the domain of tycoons, commercial property is becoming an increasingly popular investment for smaller-scale investors.

So why would you choose to put your money in commercial property, as opposed to residential?

And is it something you should consider?

Growing appeal

Commercial property is simply a cover-all term for property that’s leased out for business rather than lived in.

There are three main types of commercial property: retail, office and industrial (although some investors regard industrial as an asset class all of its own).

Rich Harvey, buyer’s agent and CEO of propertybuyer.com.au, says that with low rents and flat capital growth in many metropolitan residential property markets, he’s receiving more and more requests from clients looking to invest in commercial property.

“Many people are attracted to the better yields commercial properties offer. But there are lots of pitfalls,” he says. “And buyers should take into account all the risks before signing on the dotted line.

“Do it – but do it but with help,” Harvey says. “Don’t go in blind or half-hearted.”

The difference between commercial and residential property investment

Harvey says that one of the hardest things for new investors to get their head around can simply be understanding the mechanics of how commercial property works.

“Don’t go in blind or half-hearted.”

For starters, the value of commercial property is tied closely to the value of any leases.

But assessing the quality of a lease and its terms can be more difficult than for residential property – not least because retail and industrial areas fall in and out of favour more rapidly and it can be more difficult to attract tenants.

Leases also often come with incentives, like a discount or fit out, to attract the tenant.

“You need to closely scrutinise the contract of sale and make sure all inclusions are specified,” Harvey says.

“You also have to remember that you’re usually leasing to a business, not a person – so you need to know the financial liability of the company you’re leasing to is secure,” Harvey says.

“Do some serious due diligence on the property and the lease.”

Financing a commercial property also works differently. Typically, you need a higher deposit – at least 30 per cent – and a lender may choose to impose other restrictions, depending on where the property is located and what it is.

The upside of commercial property

Perhaps the most obvious upside with commercial property is the higher yields.

For instance, in November 2018 the gross rental yields for residential property in Sydney and Melbourne were 3.2 per cent and 3.3 per cent respectively. Yields for industrial property in the two cities sat between 5.25 per cent and 6.38 per cent.

For CBD offices in Sydney and Melbourne, they were between 4.38 per cent and 5.05 per cent. And for retail, they were between 5.15 per cent and 6.95 per cent across the whole East Coast.

“You need to closely scrutinise the contract of sale”

But Lillie Cawthorn, industrial property expert and author of The Money Factory says these high yields aren’t the only upside of commercial investing.

Cawthorn points out that, with commercial property, it’s much easier to remove the emotion than it is with buying a residential property, so buyers can more easily make a purely analytical investment decision.

Despite requiring a larger deposit, buying commercial property also often requires less overall capital outlay than residential. Cawthorn says that in Sydney, for example, industrial property can cost as much as 30-50 per cent less than residential property to generate a similar income.

For this reason, while residential property investment is often negatively geared, commercial property investment can be positively geared more easily – making it appealing to investors looking for income as opposed only to capital growth.

“The strategy behind commercial property investment is different to residential property investment,” Cawthorn explains. “Commercial is usually a long-term passive income earner, not a quick capital gain strategy.”

Leases often run longer – usually three-to-five years – and come with built-in rental increases. And tenants are usually responsible for all outgoings, including utility bills and even land tax.

Who should invest in commercial property?

Cawthorn says all of these factors mean commercial property is an obvious match for income investors.

“I’ve met many people who were ‘managing’ their ageing parents’ life savings,” she explains.

“Some had $600,000 and more of their parents money sitting in the bank! This amount could have purchased a small warehouse and earned their parent a monthly income of $1,600-$2,000.”

However, she also says that it could be used as part of any long-term investment strategy.

Harvey agrees and believes there is a role for commercial property in most portfolios because of the diversification it provides.

“You can get access to different property markets, different asset classes or market cycles,” he says.

“We have tight supply in many commercial property markets right now,” Harvey explains. “There is growing demand due to strong economic growth and in Sydney some commercial buildings have been resumed for new light rail stations which has limited the supply of commercial offices.”

Buyer beware

As with residential property, commercial property can be freehold or strata title.

Rich Harvey recommends if you’re buying a commercial strata building or unit you do the same checks you would if buying an apartment. This includes checking the strata records and minutes for any surprises.

Harvey also says that while big city CBDs are the domain of big fund managers, smaller-scale investors should pay attention to other commercial hubs with good transport and amenities, such as North Sydney, or Prahran in Melbourne.

“You can get access to different property markets, different asset classes or market cycles”

He also likes smaller suburban shops and offices which can provide strong returns and good capital growth.

Harvey says investors should always pay particular attention to the volume of new stock coming into the area, as well as to vacancy rates. In a bad economy, you should expect leases to sit vacant for up to six months – especially in the retail sector.

Seek expert guidance

Like any investment, you should always seek advice from experts before investing in commercial property.

Cawthorn says this means ensuring you are using a team of advisers who specialise in commercial property: from your real estate agent to your financial adviser, mortgage broker or lender, solicitor, and leasing agent.

This way you’ll be fully informed and in the best position to make the most of your commercial property investment.

Read more: How to nail a commercial property renovation
More: Should you invest in property through super?

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