Commercial property investing – the pros and cons
At least a dozen times a week I am asked by avid property investors why we should not all be buying commercial property. Since the rental yield on a commercial property, at around 10%, is often better than that on a residential property, at between 3% and 6%, many wonder why we should not all just run out and commercial property.
One of the things that so many property investors fail to consider is the risk factor attached to property investing. In the same way that we all know buying shares in an emu farm or olive trees will naturally be a more risky venture than putting our money in a bank, investors should be aware that the same parallels can be made between the different classes of investment property. While most investors will say that they are aware of the risk, usually they are considering the market risk (that is, the risk that all property will stagnate in value or be vacant), or the financial risk (that is, that interest rates and maintenance costs will rise or go beyond our capacity to meet). Few consider the fact not all property is equal in terms of its risks and opportunities – that each type of property also carries its own specific risk, and that commercial property is right up there amongst investments with a higher risk.
What defines a commercial property?
A commercial property is any property which has been zoned by the council as commercial, industrial or retail, and which is leased for the purposes of running a business of some type. This could include shops, offices, warehouses and factories.
When an investor buys a commercial property, the bank will provide a different type of loan and the lending criteria will be different from that of residential lending. A commercial loan usually has a higher rate of interest and will often require additional guarantees to secure the loan. It also usually has a lower loan-to-valuation ratio (LVR), most often capped at 70%, which means that investors have to provide a larger deposit, or have more equity in property elsewhere, to make the purchase.
When you buy any sort of commercial property there will be – like all property – positive and negative features to consider.
- You will get a higher rate of return for the money spent, usually around 10%, as long as you have a tenant;
- A commercial property with a history of consistent tenancy, or with a secure long-term tenant, can be easier to sell than a residential property;
- Lease periods can last much longer if you lock in a good tenant, with three to five years the standard term, and;
- The ultimate sale value of a commercial property is often linked to its return. So, for example, a property which attracts $40,000 a year in rent, at a market capitalisation of 10%, would be worth $400,000 if sold. If there is subsequent pressure on rents due to increased demand, and they were to increase to say, $50,000, the property would then become worth around $500,000. The ultimate sale value of a residential property is separate from its rental yield.
- A commercial property is likely to attract small business owners, as larger businesses very often own their own property. As more than 80% of small businesses go broke in the first five years, there is a high chance of getting tenants who will not see out their lease!
- Often, in order to attract a tenant, the landlord must offer a range of incentives, which may include fit-out, rent-free periods, etc. This can severely eat into your return, especially where leases are for a shorter period;
- Commercial property has a higher rate of vacancy, which can last for much longer periods of time. How often have you seen a local shop or office sitting vacant for months, sometimes years? If you purchased a property using loan funds, which was unable to attract a tenant, you may suffer severe financial distress with this outcome, and;
- Commercial property is affected by both the tenancy market and the general state of the economy, as the tenant’s business will suffer hardship when the economy is performing poorly. Therefore, in addition to the market risk which relates to the potential success or failure of property within the area where you are buying, there is a specific risk with commercial property not seen in residential, which relates to the commercial viability of the particular business of the person who becomes your tenant.
The risk of investing in commercial property would be considered medium when compared to other, non-property investment vehicles, and medium-to-high when compared to other property types. This means that, when you buy commercial property, you are taking more of a risk than you take when buying other property, in particular residential property.
The decision to buy any commercial property must be based both on the potential of the property to satisfy successful investing criteria as well as a consideration of your own personal risk profile. If you have never had this measured, be sure to do so and find out where you are placed on the risk scale.
Then, make a commitment to buy only the kind of property which suits this risk profile. Not only does this make good investing sense, but you will feel a lot more secure and happy going forward, and you will be sure that you are buying property that is right for you and suitable for your personal financial circumstances.