Commercial property – Part 1: The risks and the rewards! (Ep.61)

In this week’s episode of the Property Planner, Buyer and Professor Podcast, the team take you through the ins and outs of investing in commercial property.   

In this episode David Johnston, Cate Bakos and Peter Koulizos discuss: 

  1. How commercial property investment differs from residential, from a higher return on investment, duration and construction of leases, flexibility in lease length, business category of tenant and to ongoing running costs.   
  2. An introduction to the different types of commercial property – industrial, retail and office. 
  3. Higher return also means higher risk, and that risk comes in the form of vacancy rates, rental volatility and higher funding costs. It’s often much easier to find a tenant for your home, than your warehouse or high street shop.  
  4. The high cost of entry and ongoing maintenance. Buying commercial property is often much more expensive than buying residential property, on top of that commercial property investment requires higher deposits as a direct result of lower loan to value ratio constraints, and higher interest rates for commercial lending.  
  5. Real estate investment trusts and how you can invest in commercial property without purchasing the whole building; Dave touches on this exciting purchase pathway, but only scratches the surface. The trio look forward to delving even further into REIT’s.   
  6. Volatility in the commercial market as a result of the Covid-led economic slow-down, with sentiment dropping to unprecedented levels for some categories, dire vacancy rates are the market indicators. 
  7. The economic outlook for retail, office and industrial commercial property including some positive insights for specific subsets of commercial property 
  8. And of course, our ‘gold nuggets’! 

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Show notes

  • Different types of commercial property 
    • Industrial property is defined as a property used for the actual manufacturing of something, and can be considered either a factory or plant. This is usually zoned for light, medium or heavy industry. This includes things such as warehouses, garages and distribution centers etc. 
    • Retail property is a commercially zoned property used solely for business purposes, the actual selling of the product, rather than its manufacture — retail stores, malls, shopping centers and shops all huddling nicely under the retail umbrella. 
    • Office real estate is commercial property that is set aside for business. Office space can be found in single buildings, business parks and huge CBD office towers. Offices require desk space, meeting rooms and facilities such as kitchens and toilets. 
  • Considerations for commercial property 
    • Return  Residential property investment is relatively low risk and as a consequence, low return. Commercial property has a higher return, but this comes at a higher risk. For example, a flat or unit will average a return of 5%, whereas industrial property, such as a warehouse, may average 8%. For industrial you can have double digit returns, however it comes with higher risk than office and retail.  
    • Duration of leases – Residential leases tend to be for six or 12 months. However, commercial property leases are generally for a much longer period of time. It is not uncommon to have leases that are for an initial five-year period, with the option to renew for another five years. 
    • Flexibility in lease length– it depends on what kind of commercial property uses for property. The landlord does not pay for plant and equipment, the tenant does – they want that for years – 5 years with 3 options. A shop in the street might want only year by year, but for the term of 5 years. If they are a recognised business on that street corner, that’s part of their identity – how much money has been invested and commercial reputation built.  
    • Quality of tenant – The tenant is obviously a crucial part of your property investment. In commercial property, a government or large corporate tenant is considered a ‘blue chip’ tenant. They are likely to rent your property for a long period of time and are unlikely to default on the rent. 
    • Maintenance costs – Upgrading a residential property is relatively cheap. A paint job, new floor coverings, kitchen and bathroom can cost as little as $20,000 to $30,000. Refurbishing a commercial building, however, can be costly. New air-conditioning, upgrading the building to meet new health and safety standards and refits may cost 10s or even 100s of thousands of dollars. However, the costs are rarely borne by the owner. 
  • Risks with commercial property 
    • The higher risk comes in the form of higher vacancy rates. Let’s use the warehouse example. It could take a while to find a new tenant for the warehouse, many months and possibly more than a year. Conversely, finding a new tenant for your residential property might only take weeks. Additionally, if the sole tenant of your property has to close due to tough economic conditions, you could face some hard times. On the other hand, residential property can be resilient when it comes to economic factors over the long term. 
    • If there is a dispute, you must go to court – there is no to appeal to Tribunals, which are cheaper and quicker to resolve. You need access to funds if you want to fight for what you think is right.  
  • High cost of entry, you need deep pockets for ongoing maintenance 
    • Buying commercial property is often much more expensive than buying residential property. CBD office or retail space is generally the most expensive space, due to its locality. Industrial property on the outskirts of the city can also be expensive due to size of the property being purchased. Costs, however, can minimised by purchasing smaller strata title premises. 
    • Commercial lease agreements are costly to get in place and everything is up for negotiation.  
    • Lending – Loan to value ratios – borrow 60%-70%, higher interest rates, amortised loans – the outgoings are enormous. 
  • Commercial market volatility 
    • NAB quarterly Australian commercial property survey – Jul 2020 
    • The COVID-19 led economic slowdown had a major impact on commercial market sentiment in Q2, with NAB’s Commercial Property Index falling to an unprecedented -62 points (surpassing the previous low of -19 in Q3 2012). 
    • Sentiment collapsed in Retail (-76), Office (-68) and CBD Hotels (-60), but the fallout for Industrial property (-28) was comparatively limited. 
    • Office vacancy hit a 2-year high 8.5% in Q2, and climbed steeply in VIC (7.4%) and NSW (6.7%). Retail vacancy also hit new survey highs (9.0%), but industrial property remained insulated, with vacancy falling (5.8%). 
    • Covid-19 – there will be a lot of business that don’t return after second lockdown – tenants are not coming back. In the long-term – we’re all working from home. If the boss of this office says that they can have half-staff, working from home half the time, I only need half the square metreage. Vacancies will increase and rents will drop.  
    • Retail has taken a big hit since GFC and uptake of online retailing – less demand for bricks and mortar. However, people still want to go to the supermarket to purchase groceries.  
    • Industrial – warehousing everything – now we’re going to ‘just in time’ – only stock what you need for a week or two. Now we are moving to ‘just in case’ stocking – if borders close, you need enough stock to last you longer. 
    • More investment in areas further away from the city – regional uptake in commercial space as well.  
  • Real estate investment trusts   
    • If you want to invest in commercial properties but don’t have the capital or the desire to purchase a whole building, real estate investment trusts (REITs) can achieve the same end in more manageable portions. 
    • A real estate investment trust is an investment vehicle for real estate, where investors can buy a stake in property assets (including buildings and mortgages) without tying up their capital in the long term. REITs can be traded, like stocks, on major exchanges. They give investors exposure to large-scale real estate assets, including warehouses, hospitals, shopping malls and apartment buildings. 
    • 80% of the value on ASX 300 – publicly listed 
    • Private REIT as well.  
  • Commercial zoning 
    • When you think you are buying something to live in and it looks like a house – if you purchase something which is commercially zoned for the purpose of living in it, if it’s commercially zoned, you may find that the bank treats it as such.  

Peter Koulizos – The Property Professor’s Golden nugget: commercial property can be risky and you need to minimize that risk and one way is flexibility. Maybe you have a house on a main road and it was being used by an accountant, maybe it can be converted back to a house. But if you have a purpose-built property, then your only tenant after that is another printer and printing is a decreasing industry. If you’re going to buy commercial property, look at the flexibility of uses.  

Cate Bakos – The Property Buyer’s Golden nugget: if you’re contemplating commercial acquisition, think about it like the monopoly board, you need to get a few green houses under your belt before you go for the red hotel.  

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