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Are commercial properties a good investment?

  • June 23 2020
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Invest

Are commercial properties a good investment?

By Zarah Mae Torrazo
June 23 2020

Thinking of buying a commercial property but unsure if it’s a good investment? Let’s take a closer look at how commercial investing works and if it’s the right fit for you. 

Are commercial properties a good investment?

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  • June 23 2020
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Any type of investment property (whether it’s commercial or residential) can be a good opportunity to grow your wealth. While commercial properties are perceived to offer bigger financial rewards compared with residential properties, you should also be aware of the higher risk that comes with it.

 Let’s take a look at how investing in commercial property works so that you can decide if it’s the right investment for you. 


What are commercial properties?


Commercial property is a real estate property that is generally used for business activities. It usually houses businesses, but it can also refer to a land that is used for income-generating purposes (e.g. car parks) and bigger residential properties, such as a community strip mall. 

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Commercial real estate may refer to any of the following: 

  • Office buildings
  • Warehouses
  • Industrial buildings
  • Retail buildings
  • Apartment buildings
  • Mixed-use buildings (retail, office and apartments)

While these are all considered to be commercial properties, there is a difference in managing each of these types of properties. Take note that the designation of commercial property also has implications on the financing of the building, its tax treatment and the laws that apply to it. 

What factors affect the demand for commercial properties?

Prices of commercial real estate can go up or down based on market conditions. And while it might be impossible to accurately predict the fluctuation of prices, here are some main factors that affect demand to help you make smart financial choices with your investment. 

  • Cash or interest rates: An economic environment with low interest rates or cash rates set by the Reserve Bank of Australia will support demand for both property and borrowing. On one hand, increasing interest rates could slow demand for commercial real estate due to the increased cost of finance and rent. 
  • Population growth: There is strong demand for commercial properties in suburbs with strong population growth usually brought on by gentrification. Gentrification is the process of change in the character of a neighborhood through the influx of more affluent residents or tenants and businesses. This usually means that the suburb will need new services, including shopping centres, transport links, financial service firms and restaurants, which can be potential commercial tenants.  
  • Population demographics: Demographic data refers to the composition of a population, including age, race, gender, income, migration patterns and population growth. These figures are often overlooked, but this is a significant factor that affects how prices in the real estate move and what type of properties are in demand. For example, as Australia’s Baby Boomers transition to retirement, there is greater demand for healthcare facilities and medical centers. Such a shift in the demographics of the country is seen to have a big impact on real estate for several decades. 
  • Infrastructure projects: Large and anticipated projects can increase the demand for commercial property. For example, if a new passenger rail project is in development, it can generate demand for centres providing a mix of retail, residential, recreational, entertainment and commercial uses.

How does commercial property investing differ from residential property investing?

While there may be some similar characteristics between commercial and residential properties, they are not the same. 

Both properties entail renting out the property and receiving rental income from a tenant. The differences between commercial and residential property investing are mainly: 

  • Longer lease periods – Commercial agreements are typically for a longer period of time compared with residential leases.
  • Longer vacancy periods – Vacancies between subsequent tenants are generally longer for commercial properties. 
  • Tax treatment – Unlike residential property investing, the goods and services tax applies to the purchase, income and expenses associated with a commercial real estate, which means an additional 10 per cent to the property purchase price if the property is unoccupied. But this can be claimed back under an “input tax credit” with the Australian Taxation Office. 
  • Fewer maintenance expenses – Generally, tenants pay for the repair and maintenance of a commercial property during the lease period. This equates to higher rental yield compared with that generated from a residential property. 

Pros and cons of commercial property investing

To have a general idea of what it’s like to be a commercial investor, let us look at the pros and cons of commercial investing. 

 Pros of commercial property investment

  • Higher return on investment – Commercial property (when occupied) generally provides a higher return on investment compared with residential properties. 
  • Long-term leases – The average lease for a commercial real estate is from three to 10 years (or even longer). Commercial tenants who have invested some capital in the premises, such as upgrading the fit-out, would be more inclined to have a longer-term lease. This provides you with a prolonged period of rental income security. Meanwhile, average leases for residential properties usually range from six months to a full year, and there is no guarantee that the tenants will choose to renew their lease. 
  • Less ongoing costs – Commercial tenants are usually responsible for a property’s expenses, including council rates and water use, insurance or body corporate fees, which means less ongoing costs compared with managing a residential property. Additionally, property management fees for commercial properties are lower compared with those of residential properties. You can also avoid paying capital gains tax if you choose to sell commercial properties.  
  • Value-adding tenants – Tenants tend to add value to commercial properties by making improvements to the structure and layout of the space they leased. These “upgrades” can boost the property’s value. As rent is reviewed annually, you can charge a high rental amount to better reflect the improvement in the premises. 
    Price stability – Historically, commercial property prices have experienced lower levels of volatility compared with other investment assets. 

Cons of commercial property investment  

  • Rent-free periods – Untenanted periods mean loss of rental income. Commercial properties are at risk of being unoccupied for extended periods, which means you may have to cover expenses until you can find a tenant to replace the previous one. This also affects your capital growth, which can be stagnant if your property is vacant for a long time. 
  • Vulnerable to economic factors – Economic factors, including a market crash, increasing interest rates, high unemployment rate or dampened business confidence, can hurt demand for commercial property. And with these economic factors affecting a potential tenants’ ability to pay rent, it may also be difficult to find quality lessees.  
  • Big upgrade costs – While the costs of upgrading a property will depend on its type, renovating a commercial property is generally more expensive compared with renovating a residential property. 
  • Higher upfront capital – Lenders usually require a bigger down payment to purchase a commercial property. Sometimes, banks will ask for a deposit that is twice that of a residential property.
  • Stricter mortgage requirements – Because commercial properties are considered to be riskier, commercial real estate loans require more scrutiny than residential mortgages. Small businesses are considered risky by lenders, and many don’t end up turning profit. This means that banks generally lend lower against them as well, resulting in mortgages with high interest rates. 

Conclusion

Many steer away from investing in commercial properties due to its perceived higher risk compared with residential properties. But if you buy a well-chosen commercial real estate, it can provide significant cash flow benefits, greater rental certainty and lower ongoing costs. 

With the right research, due diligence and knowledge of the risks involved, commercial real estate can be a valuable and profitable addition to your property portfolio. 

Are commercial properties a good investment?
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