The risks & benefits of commercial: Going in with your eyes wide open
For decades, commercial property has been considered a “rite of passage” by many investors. They graduate beyond houses and units, dabble in renovation or a small development, and then reach a point of looking at a commercial option. And while there are plenty of upsides to consider, there are also multiple risk considerations to take into account as well.
Commercial on the rise
There’s been a resurgence in demand for commercial real estate over recent years.
For a start, technology means we have easy access to wide-ranging information about the sector. This has removed much of the mystery surrounding this seemingly “more sophisticated” asset class. As such, commercial has become more accessible than ever to the average investor.
Secondly, those seeking higher returns are having difficulty finding assets to fulfil their need in the current market. We have ridiculously low cash rates which means returns on cash deposits at the bank are barely worth the effort. In addition, a rise in residential values over the past decade has eroded yields to incredible lows.
Another reason for increased interest in commercial is that, especially for many boomers in their retirement years, the complications of managing a residential property vs the relative “set-and-forget” nature of commercial make the choice easy. Residential investments require ongoing maintenance and management. Tenancies are relatively short (compared to commercial) and tenancy legislation can feel onerous. On the flipside, commercial provides and easy option where tenants look after outgoings and are locked in for longer.
Then there are the returns. Commercial property can achieve a couple of percentage points more in net yield compared to similarly located residential. That said, demand for commercial property has reached the point where yields now track at around the 4 per cent net mark. It’s a far cry from the 6-to-8 per cent returns from a few years back.
So, demand is on the rise and the reasoning seems sound – but this does not mean we should all be rushing to commercial property without weighing up the other side of the ledger.
The risks and rewards
What are some of the basics you need to understand about a commercial investment?
Well, for first-time commercial buyers, never purchase an untenanted property.
Value resilience and loan serviceability are absolutely contingent on the lease you have in place. A vacant commercial acquisition is a risky venture with challenges around securing the right tenant at an appropriate rental and under acceptable terms. The hunt can take months and all the while, your position in terms of cash flow, and potentially asset value, are going backwards.
In short, a stable tenant is the key to commercial investing.
Also – you need to use experienced professionals to help you with the investment. You must use solicitors, financiers and other advisers who operate in the commercial space and understand the specific nuances of dealing in the sector.
Next – understand that the fundamentals of value are different between residential and commercial. Sure, location is key but for different reasons. For instance, ready access to major transport routes for heavy vehicles might be essential for a warehouse-style investment. This is the reverse of residential where close proximity to busy major roadways is seen as a detriment.
The functionality of the property must also meet the needs of a commercial tenant. It’s no good having a light industrial shed pitched toward a business that takes delivery of stock via trucks, only to realise there’s no room for a big vehicle to manoeuvre onsite. You’ll never secure a tenant.
Commercial investors must also understand the broad economic landscape to identify what sort of investment to make. For example, I’ve seen people chasing regional retail holdings that present an attractive yield proposition. But these will cause no end of headaches in the long term because the retail environment is rapidly changing. Regional retail is doing it even tougher than their city cousins and you could soon find you’ve paid for bricks and mortar that can’t secure a tenant. And as I already mentioned, vacancies in commercial can be death by a thousand cuts.
Another element is finance. Often, you’re required to put in a much higher deposit as part of a commercial property loan. In addition, loans tend to be provided over dramatically shorter periods, with ongoing annual audits of your financial position and more frequent full-refinance applications needed. The potential risks associated with this must be taken into account when making your decision.
How commercial fits
This sector works best in certain circumstances and is an important component of an overall portfolio.
A commercial holding should never be the “cornerstone foundation” of the investment cache you’re building. It can underpin your cash flow, but must work well in tandem with the capital-gains assets you’ve selected as well.
You absolutely must apply comprehensive due diligence too. In fact, I believe you need to be more conscientious by many multiples with commercial as compared to residential, because the downsides can be severe for inexperienced buyers.
The best way to mitigate these risks is to lean on the professional advice from an expert in the commercial property realm. They can guide you as to what assets might work within your portfolio, and the ones to avoid.
Like any asset, a commercial investment must fit within your overall strategy and help deliver on the long-term goals you set yourself.
