If you’re thinking of investing in commercial property as a way to diversify your portfolio, make sure you understand the risks.
If you didn’t know already, the commercial space is very different to residential real estate: you could earn a much higher return but there are also greater risks involved.
Commercial properties are highly exposed to economic uncertainties
Economic downturns can affect the residential property market just as much as commercial, but it’s commercial property that take the most dramatic hit when it occurs.
For example, when the economy slows and unemployment rate goes up, consumer spending goes down. People tend to spend less on discretionary spending.
The reason is simple: if Australians aren’t spending money, businesses won’t be willing to start-up or expand into the new commercial premises.
The fundamentals of the area could change for the worse
When looking for a commercial property, you should consider:
- Accessibility to transport links
- Proximity to businesses that will help support the businesses of your potential tenants such as transport companies and wholesalers.
Where property investors who are new the commercial market fail is researching and planning into the future.
For example, while the area today might be just right for the office space you want to buy, it’s often an afterthought to check out what the local council has planned in the not too distant future.
Zoning for the office block could change from commercial to residential as a result of new suburbs being rolled out across the area.
Unless the office can be easily converted for residential use, the strata company need to sell the property to a developer or spend significant capital to refurbish the office so it meets residential standards.
Selling to a developer is great news if your strategy is capital gain but not if your aim was for long-term rental return from high-yielding commercial tenancy.
Like the residential market, having a number of similar types of properties flood the market in your area creates more competition to attract tenants.
It can even have a massive effect on your ability to retain current lessees, particularly if own an older building and the lessees are looking to upgrade to bigger and better business premises.
Strong supply essentially reduces potential yields as commercial landlords bend over backwards to hook tenants.
Wait, isn’t the development infrastructure projects like train lines, retail centres and motorways a good thing for commercial property investors?
Yes, they are, but only if it’s happening in your area!
If these kind of projects are taking place elsewhere, it has the potential to draw potential tenants away from your property.
It’s difficult to get an accurate market valuation
One of the main tools used by valuers when valuing a commercial property is the capitalisation rate (cap rate).
The problem is that trying to determine the potential return on investment for the commercial property works on the premise that revenue estimates for businesses are accurate and that the market value of the property will remain unchanged.
It’s also difficult to back up a market value estimate with comparable sales since you may not be able to find 2 or 3 of exactly the same property type in the area to compare to. This a unique problem in the commercial real estate market.
It’s costly to maintain a commercial property
One of the great things about commercial properties is that many of the outgoings including council rates, insurance, repairs and maintenance are paid for by the lessee.
However, it’s still important to consider the age and condition of the building structure before committing to the investment.
Some buildings need love
The building should be structurally-sound and have the flexibility to change the interior layout easily to suit all types of businesses.
Aren’t these costs for the tenant?
Technically, they are, however, you also have to consider whether it will attract businesses that want to set up shop.
You may have to pump in some of your own money to get the building up to scratch.
For specialised commercial properties like child care centres and aged care facilities which have strict building codes designed to minimise health and safety issues, the costs can be in the tens of thousands.
Other examples include chemical treatment facilities and medical centres and the may need special council approval in order to operate for their intended purpose.
At the very least, you may have to help pay part of these fit-out costs just to get the tenant to sign on.
High cost of entry
Compared to residential real estate, commercial properties can comparatively more expensive, particularly when it comes to retail and office space near the CBD.
Industrial property can also be expensive even though they’re generally not located in prime CBD locations. It has more to do with the size of the property.
This in itself presents a double whammy of sorts as larger commercial properties can be more difficult to sell that small office and retail suites.
Not a risk, per se, but it’s important to note that the goods and services tax (GST) applies to the purchase price, rent received and any expenses in relation to the property.
Higher risk of long term vacancies
One of the harsh realities when it comes to commercial property is that you’re tied to the tenant – they’re not tied to you.
Depending on the economic environment and the level of competition in the area, you’re constantly trying to “win” tenants as if you were a business owner.
Commercial property risks really don’t come much bigger than vacancy rates.
For a warehouse, factory or other industrial property, you could be waiting for many months and even up to a year to find another tenant.
Compare this to 1-2 weeks for a residential property!
The value of commercial properties is very closely related to the lease so if the premises become vacant, or the lease is about to expire, the property value falls quite dramatically, in most cases.
Of course, this in itself presents an opportunity to get a great price on a property in the knowledge that you’ve done your research on market trends and expect the particular sector, whether it’s office, retail or industrial, to turn around soon.
Making a strong offer
When it comes to residential investment properties, the worst case scenario is that you drop weekly rent by a few dollars if you can’t seem to find a tenant.
You have to do a lot more than that with commercial properties including offering rent-free periods (sometimes up to 6 months) and agreeing to part-fund capital works and fit-out costs.
The major risk here is that you’re changing the lease term for a client that may either go out of business in the next year or two or simply move to a new location.
How to reduce your risks when investing in commercial property
Ultimately, the best thing you can do when it comes to reducing the impact of commercial property risks is to take a hands-on approach when undertaking your due diligence.
Read market reports and be informed when it comes to business trends. There’s plenty of information out there.
Of course, separating white noise from facts can be difficult if you don’t have a team of experts to support you, including:
- A commercial mortgage broker who can help you secure a commercial property loan that it is competitively priced and best suits your investment needs.
- A solicitor that specialises in commercial property purchases and can help ensure that heads of agreement is in your best interests when purchasing the property from the vendor, as well as drafting up the lease agreement with your lessee.
- A commercial buyers agent who can help you source a quality tenant and negotiate the lease term to win them.
- A property manager who can help you manage your tenants, ensuring rent is paid on time and keeping you informed of any changes the lessee wants to make to the property.
What are the golden tips for reducing commercial property risks?
- If you’re just starting out, consider purchasing smaller, stand-alone retail shops or buildings that are strata title rather than large commercial real estate.
- When building a commercial portfolio, be weary of being too heavily-weighted in certain property types.
- Avoid buying a multi-tenanted block of units because the vacancy risk is considerable.
- Learn to identify opportunities by taking a risk, for example, an office block may not be worth much at the moment but a new freeway construction could see the property value skyrocket.
- Make sure the lease agreement is correct and you know exactly what your rights and responsibility are. Your solicitor and a buyers agent will help you to negotiate a lease that’s fair for you but won’t put off any potential tenants.
- Keep an eye out for infrastructure projects that are going ahead in the next few years. What type of business will they attract and do they match the commercial property you’re looking to invest in?
- Infrastructure projects go hand in hand with the rollout of new suburbs, which also presents opportunities for child care centres and the need for aged care and health care facilities. As more families move in, it makes sense to invest in small offices in the area to match the desire of people to work closer to home. It also pushes up demand for shopping centres, retail stores and cafes.
- Review your tenants carefully including their financial strength. Ideally, you’ll want to aim for so-called “blue chips” which are corporate and government tenants.
- You may have to offer a longer lease term in order to attract more potential tenants.
- Do some research and look at areas where lessees are paying under market rental. This will allow for improvement in the quality of tenants over time. This will help attract buyers who are willing to pay a premium for the property when you eventually decide to sell it for capital gain.
- Look into different ways that you can increase your commercial property value to attract tenants and potential buyers cheaply.
No one can predict the future but it’s always best to make an educated decision on when to buy and when it’s time to sell.
Do you need a commercial property loan?
Call us on 1300 889 743 or complete our free assessment form to speak with one of our commercial loan specialists.