In previous blogs we have discussed some of the advantages of commercial real estate as an investment. In this blog we will explore what an investor should look out for.
Advantages of commercial real estate project
Backdrop
Commercial property usually produces much higher income than an investment in a residential property, and the quality and strength of the income, in turn, largely determines the value of a Commercial property. So as an investor, you should consider not only the scope for capital gains but importantly, the quality of the income.
Quality of the Tenant(s)
The quality of existing tenants is key. You should consider the following questions:
- Are the tenants of high quality and likely to be able to continue paying rent? For example, government and large corporate tenants are more likely to meet their rental commitments and extend their leases.
- Are the tenants in a growing sector of the economy?
- Are there multiple tenants? A diversity of tenants reduces the risk of a rental shortfall in the event that a single tenant leaves.
- Are any of the tenants involved with hazardous activities such as hazardous chemical usage or waste disposal? These kinds of activities often require special licensing and facilities which increase the "risk" of the property.
- What is the remaining term of the lease(s)? Commercial leases usually take longer to replace than residential, and may require upfront incentives or fit-out costs to be met.
- Do the leases include automatic increases? These are usually linked to inflation.
- Do the leases cover outgoings? In many cases commercial tenants pay for outgoings and normal building maintenance.
Quality and location of the building
Maintenance and upgrade of commercial properties can be very costly, so look for high quality property:
- How old is the property? Does it need maintenance or refurbishment in the short / medium term? An older property may require substantial capital expenditure to meet modern tenancy requirements.
- Is the building flexible? Can the building easily accommodate different types of tenants? For example, an auto-repair facility is only suitable for a single purpose.
- Is the building well located? Is it close to public transport links or easily accessible? Are there alternative properties nearby?
- Are there any planned infrastructure improvements or other developments in the area which could affect the amenity of the building (positively or negatively)? This may include new infrastructure such as train lines or road access.
- Are there any new commercial developments in the vicinity (planned or in progress) which may compete with the property? New tenants may be attracted to new commercial properties which offer better facilities and lower maintenance and energy charges compared to an older building.
The rental yield
Commercial properties may offer opportunities to increase the overall rental yield (ie. the rental returns as a % of the building value). Consider the following:
- Is the current rental yield above or below market?
- Can the rental yield be improved? For example, is the building fully occupied?
- Is there scope to improve the building to attract higher rentals?
Lease considerations
Commercial property leases can be complex and lengthy, and may include terms and conditions which have been negotiated for a specific tenant(s). This is in contrast to residential tenancy agreements, which are usually based on a standard template.
As an investor it is important to have an expert review undertaken of the lease agreement, particularly if it has been specifically tailored for a large tenant.
Conclusion
An investment in Commercial Property is as much about the income from rentals as potential capital gains. Properties with quality tenants in a good location can provide a consistent, on-going net rental return of 5% and 10% which makes a healthy addition to any investment portfolio.
Related article
The information in this article is general in nature. Any advice it contains is general advice only and has been prepared without taking into account the objectives, financial situation or needs of any particular person.
The article content is not intended to be a substitute for professional advice and readers are urged to seek their own appropriate advice before making decisions.
Any reference to a particular investment is not a recommendation to buy, sell or hold the investment.
Aug 19. 2015
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