.png)
However, I have had clients who are well researched and educated about properties, investments, and the economy, who purchased multiple commercial properties for investment purposes, i.e., to lease it to tenants and earn rental income before buying their first residential property.
If you are starting to pay attention to commercial property as an investment option, this article will be a good introduction for you to see a comparison of some of the differences between commercial and residential property investment. We will talk about some of the reasons which might make investing in commercial properties more attractive than residential property, the Pros, and the factors that make it riskier and more difficult to invest in, the Cons.
“Usually, it is not common for people to purchase a commercial property as their first investment because it is more complicated and riskier than residential property"
The PROS
1. Higher rental yields
Due to the higher risks and investment of resources required, commercial property investment, in general, will give higher rental yield. The rates of return vary greatly depending on many factors, which I will go into details in another write-up. Using Victoria as an example, rental yield can range from 2% for a Melbourne CBD freehold with potential development prospects to over 10% for a retail shop in regional areas.
2. Tenants pay for outgoings
These can include, as negotiated between tenants and landlords, utilities, council and water rates, body corporate fees, insurances. Typically, you will only have to pay any applicable land tax associated with the ownership of the property. This is the opposite of residential leases where tenants pay only rent, and everything else comes out of your pocket.
3. Longer leases
The tenant usually prefers to be on the same premise for their business if it goes well. Typically, new businesses may start with a shorter lease term of 2-3 years with option(s) to renew the lease. Established business or experienced business owners may take up a longer initial lease term to negotiate for a lower rent.
4. Annual rent increases
The rent increase can be from 3% to 4% each year, which is higher than recent years’ CPI of around 2%. The increased rent will also improve the valuation of your property as it is one of the key factors considered in commercial property valuation.
5. Commercial lease agreements are commercial in nature
You, as the landlord, and the tenant will agree upon all the terms and conditions of the commercial lease. In contrast, residential leases are governed by the Residential Tenancies Act, which mandates that the landlord has certain obligations, and the tenant has certain rights.
6. Less headache once tenanted
Tenants usually will invest in the fitting out of the property and will look after it, while paying to fix anything that goes wrong, as it is their trading premise. In general, you will have less to worry about after having the property tenanted.
7. You can pick one that suits you from a wide range of options
In terms of price points, if you want to go big, obviously the sky is the limit, and on the other end of the spectrum, there are commercial properties that can be acquired for under $100,000. Therefore, there are always investment opportunities that suit your financial situation. Besides this, you can choose to invest in certain property types or target potential tenants in a specific industry that you know well and understand the risks involved.
The CONS
1. You need to have more cash You will have to come up with typically 30% of the purchase plus Government charges and GST if applicable. This is because commercial loans are usually up to 70% LVR. LVR can go up to 80% if you have a stronger income or down to 30% to 40% if you have no income, other than the rental income from the property itself. 2. You need to have even more cash! Apart from what has been mentioned above, everything costs a little bit more, and you will have to pay more out of your pocket. The extra costs include up-front borrowing fees, commercial valuation fees, legal fees for preparation of lease agreement, possible GST, noting that when you have to pay GST, stamp duty is calculated on the sum of the purchase price and GST. 3. You need to deal with a more complex tenant selection process and lease agreement The tenant of a commercial property is almost always a business, which, generally speaking, is less stable financially than the average residential tenant who earns a wage, especially if it is a new business. Each business tenant brings different risks, and the lease agreement will need to address these risks to a point where both you and the tenant are happy with the agreement. 4. Demand for your commercial property is more sensitive to external factors These factors could be the broader economy and economic cycles, the local economy, trends in different industries, etc. This means you need to have a more comprehensive understanding of economics to reduce the risks when making an investment decision or finding a tenant for an existing property. 5. Longer vacancies and rental incentives It usually takes more time to find a tenant for commercial property. And when you found one, it is quite common that the tenant will request for incentives such as a rent-free period for them to fit out the property before they can start trading from the premise. You need to factor these periods in not only the net return calculation but also the cash flow impact because you will have to cover all of the expenses for these periods. Besides any repairs and maintenance, think loan repayments, insurances, and all outgoings, which are usually covered by the tenant when there is one. 6. Financing can sometimes get a little complicated If you have a good understanding of how banks assess home loan applications, be prepared to get used to answering another set of questions. While the fundamental criteria for assessing a loan application are similar, which is income vs. commitments, there are many factors involved, and each case can be completely different. As a prime example, I have been able to obtain a commercial loan for a client, without the bank asking for any income documents except for the lease agreement of the property purchased. This is pretty much impossible when it is a residential property. There is much more to talk about, and even though it is my area of expertise, I will not go into further details because it is my trade secrets… just kidding… because this topic deserves a whole write-up for itself, and we will explore it another day. So there you have it, an introduction to some of the points of difference in commercial property investment in comparison to its residential counterparts. Feel free to ask questions, correct any of my mistakes, and let me know which topic you would like me to dig into next. As always, please do not hesitate to contact us directly if you need help.
Kind regards,
Kien Phan & Phuong Nguyen.
The PROS
1. Higher rental yields
Due to the higher risks and investment of resources required, commercial property investment, in general, will give higher rental yield. The rates of return vary greatly depending on many factors, which I will go into details in another write-up. Using Victoria as an example, rental yield can range from 2% for a Melbourne CBD freehold with potential development prospects to over 10% for a retail shop in regional areas.
2. Tenants pay for outgoings
These can include, as negotiated between tenants and landlords, utilities, council and water rates, body corporate fees, insurances. Typically, you will only have to pay any applicable land tax associated with the ownership of the property. This is the opposite of residential leases where tenants pay only rent, and everything else comes out of your pocket.
3. Longer leases
The tenant usually prefers to be on the same premise for their business if it goes well. Typically, new businesses may start with a shorter lease term of 2-3 years with option(s) to renew the lease. Established business or experienced business owners may take up a longer initial lease term to negotiate for a lower rent.
4. Annual rent increases
The rent increase can be from 3% to 4% each year, which is higher than recent years’ CPI of around 2%. The increased rent will also improve the valuation of your property as it is one of the key factors considered in commercial property valuation.
5. Commercial lease agreements are commercial in nature
You, as the landlord, and the tenant will agree upon all the terms and conditions of the commercial lease. In contrast, residential leases are governed by the Residential Tenancies Act, which mandates that the landlord has certain obligations, and the tenant has certain rights.
6. Less headache once tenanted
Tenants usually will invest in the fitting out of the property and will look after it, while paying to fix anything that goes wrong, as it is their trading premise. In general, you will have less to worry about after having the property tenanted.
7. You can pick one that suits you from a wide range of options
In terms of price points, if you want to go big, obviously the sky is the limit, and on the other end of the spectrum, there are commercial properties that can be acquired for under $100,000. Therefore, there are always investment opportunities that suit your financial situation. Besides this, you can choose to invest in certain property types or target potential tenants in a specific industry that you know well and understand the risks involved.
The CONS
1. You need to have more cash You will have to come up with typically 30% of the purchase plus Government charges and GST if applicable. This is because commercial loans are usually up to 70% LVR. LVR can go up to 80% if you have a stronger income or down to 30% to 40% if you have no income, other than the rental income from the property itself. 2. You need to have even more cash! Apart from what has been mentioned above, everything costs a little bit more, and you will have to pay more out of your pocket. The extra costs include up-front borrowing fees, commercial valuation fees, legal fees for preparation of lease agreement, possible GST, noting that when you have to pay GST, stamp duty is calculated on the sum of the purchase price and GST. 3. You need to deal with a more complex tenant selection process and lease agreement The tenant of a commercial property is almost always a business, which, generally speaking, is less stable financially than the average residential tenant who earns a wage, especially if it is a new business. Each business tenant brings different risks, and the lease agreement will need to address these risks to a point where both you and the tenant are happy with the agreement. 4. Demand for your commercial property is more sensitive to external factors These factors could be the broader economy and economic cycles, the local economy, trends in different industries, etc. This means you need to have a more comprehensive understanding of economics to reduce the risks when making an investment decision or finding a tenant for an existing property. 5. Longer vacancies and rental incentives It usually takes more time to find a tenant for commercial property. And when you found one, it is quite common that the tenant will request for incentives such as a rent-free period for them to fit out the property before they can start trading from the premise. You need to factor these periods in not only the net return calculation but also the cash flow impact because you will have to cover all of the expenses for these periods. Besides any repairs and maintenance, think loan repayments, insurances, and all outgoings, which are usually covered by the tenant when there is one. 6. Financing can sometimes get a little complicated If you have a good understanding of how banks assess home loan applications, be prepared to get used to answering another set of questions. While the fundamental criteria for assessing a loan application are similar, which is income vs. commitments, there are many factors involved, and each case can be completely different. As a prime example, I have been able to obtain a commercial loan for a client, without the bank asking for any income documents except for the lease agreement of the property purchased. This is pretty much impossible when it is a residential property. There is much more to talk about, and even though it is my area of expertise, I will not go into further details because it is my trade secrets… just kidding… because this topic deserves a whole write-up for itself, and we will explore it another day. So there you have it, an introduction to some of the points of difference in commercial property investment in comparison to its residential counterparts. Feel free to ask questions, correct any of my mistakes, and let me know which topic you would like me to dig into next. As always, please do not hesitate to contact us directly if you need help.
Kind regards,
Kien Phan & Phuong Nguyen.
Commentaires