What are the pros and cons of investing in a commercial property?

It’s a general misconception that the commercial property market is accessible only to more seasoned investors or those who have larger portfolios. 

And there is a grain of truth to this belief. For the unwitting or novice investor, buying a commercial property can be a daunting and complex process, fraught with risk. 

But while it may seem overwhelming to step into the commercial property market, it’s not completely out of reach; you just need to dig a little deeper into your research. 

Arming yourself with as much knowledge as possible before buying a commercial investment property could save you thousands of dollars and help you eventually get positive returns. 

To help you get started, let’s take a look at the pros and cons of investing in commercial real estate. 

What are the benefits of investing in commercial real estate? 

There are a number of benefits that can be achieved with commercial property investments. 

For those who choose to invest in commercial real estate assets, here are several significant advantages you should know: 

1. High-income potential. 

One of the key reasons investors are attracted to commercial investments is the higher rate of return they offer compared with residential properties. Commercial properties typically have an annual return of the purchase price between 6 per cent and 10 per cent. That’s a much higher rental yield range than what residential investment properties clock in, which can range from 3 per cent to 5 per cent. 

(Note: The figures are based on 2019 estimates from CoreLogic RP. This can vary depending on several factors, e.g. economic factors, market downturn etc).

2. Rental income stability due to long term leases 

Commercial leases typically last from three to five years or sometimes more. If you manage to attract and secure stable and reliable long-term tenants, such as large corporations, government institutions, or reputable brands, your rental income can be guaranteed for years to come.

3. Lower expenditures 

One of the biggest upsides to being a landlord of commercial property is the lower outgoings. Usually, tenants are responsible for shouldering costs, including council rates and any owner corporation’s fees.  

Additionally, if a tenant wants to make substantial interior changes to a premise, they will be responsible for the fit-out and the related costs and will have to “make good” at the end of their lease.

4. Diversification

If you already have a residential property portfolio, buying a good quality and strategically located commercial property is a good way to diversify your portfolio. Do your due diligence before you expand your portfolio and seek advice from experts like your financial adviser, commercial mortgage brokers, and buyers agents. 

5. Tax benefits 

As a building gets older, its structure and the assets within the building are subject to general wear and tear. This means that each year, the value of the property decreases or depreciates. The Australian Tax Office (ATO) allows commercial property investors to claim depreciation as tax deductions if the property is used to produce income. 

Taking advantage of these commercial property tax depreciation deductions can result in a significant cash flow benefit and optimised liquidity.

6. Good hedge against inflation

Historically, commercial property has been viewed as a good hedge against inflation. This is because most commercial real estate leases are structured to include annual rent increases, which helps protect property owners from the increase in expenses due to inflation. 

What are the cons of investing in commercial real estate? 

There are a number of risks and drawbacks that real estate investors should consider before buying a commercial property: 

1. High cost

Generally, commercial properties are more expensive than residential ones. While there is a real price range in commercial properties, based on location and type (retail, cafe, office space, factory, warehouse etc) their common denominator is that lenders all want more money upfront.

Banks consider commercial properties higher risk and, therefore, their LVR (Loan Value Ratio) is lower. When borrowing for a residential property, you can borrow up to 90 per cent of the property’s values. However, it’s not uncommon for the lender to require a 30 per cent to 40 per cent deposit for a commercial property, therefore only lending 60-70 per cent value.

This means that an investor will need to have a  bigger upfront investment, which can place commercial properties out of reach for some investors. The good news is that there are a number of options that allow investors to pool their money to purchase a commercial asset.

2. Property management 

Because of the size and complexity of commercial properties, these types of real estate require more management oversight compared to residential ones.

For example, in a large commercial property (e.g. shopping mall), there may be dozens of tenants, which means that traditional property management issues, such as rent collection and maintenance, will be more extensive and time-consuming. 

3. Longer vacancy periods

If you’re a frequenter of a “High Street” of shops, you have probably seen the following scenarios. On the one hand, there will usually be largely popular and successful businesses leasing for years that have become the mainstay of the location. Meanwhile, there are also shop fronts that are usually empty because they cannot seem to bag the right long-term tenants!

Commercial properties tend to have long vacancy periods, which means you will need to have enough money to cover the costs during this period without rental income. While you’re on the hunt for the right tenants, your commercial property can sit vacant for six months or even more. 

So you need to be prepared and have a cash buffer available to cover a property’s expenditures without the financial support from a rental income.

4. Vulnerable to economic shocks and infrastructure changes

Compared to residential properties, commercial real estate is more vulnerable to economic shock. This is because demand for business goods and services can dramatically rise and fall based on the strength of the economy. During an economic downturn, demand for commercial spaces usually declines. On the one hand, people always need a place to live in. 

Additionally, if the pool of your prospective tenants is on the small side, new property coming on the market in the same area can reduce your pool further, and even existing tenants may look to upgrade or expand.

Meanwhile, infrastructure changes can have a positive or negative effect on your commercial property. While improved infrastructure can attract tenants to the area, it can also lure tenants from existing commercial properties if other areas are benefiting from roads, transport, or other major upgrades.

5. Lease terms can be complicated. 

The lease term is not only important to the tenant but landlords as well. With pretty much every term up for negotiation, drawing up a lease can be an overwhelming and complicated undertaking. It’s generally advised to navigate the paper and legal work with the assistance of a lawyer, which can be tedious and not to mention expensive.   

Want to learn more about commercial property investing? We’ve got you covered. Make sure to tune in to our Inside Commercial Property with Rethink Investing podcast series, Australia’s largest and most comprehensive podcast covering all things commercial investing. 

For more investor stories, insights and information on commercial real estate read all about it on Smart Property Investment’s Commercial Property Page.