Freehold commercial Investing

Hi
I have a chance to buy a freehold commercial property.  I have been a residential property investor for many years and have done very well.  This is my first attempt to go commercial.  I can get this property of a number of shops in the main street of a country but growing town.  The price is over $1m and the lease return is about 7.5% which seems to me to be good as I can borrow the lot for under 6% (using my home for security or 7% using the freehold property).    The shops are all in good condition and the leases are 5x5.  The leases terms increase the rent by 2.5% each year.  Am I missing something important in proceeding with this or does it look a good thing to do?  

Is it an unsafe way to go or is it better to stick to residential properties which have done me well?

Cheers
Carpe 
 

There are many things to consider when entering a commercial deal, least of all is the rent.

You will need to undertake complete due diligence on the site, including have a qualified person look at things like any airconditioning systems, lifts, essential services compliance etc.

You will also need to review each lease as there may be subtle differences between each one.

Is the return nett or gross?

Rent reviews at 2.5% are below CPI, you will need to make a call whether you are prepared to accept such a low rate of review when CPI is projected to run above the long term average of around 3%.

I am opinionated. Take me at face value, read between the lines. The wise man only believes half of what he hears, a genius knows which half.

Thanks ......yes I realise there will be lots to do pre buy and  thanks as I had not thought about some of what you have said....  to me the return on an investment is the most important....low return and low capital gain prospects rules out any further consideration on a buy.  There are 4 shops, factory for producing the items for one shop (and a 2storey spacious renovated house).  Two of the shops are 1x1 leases but have been leased for a number of years to the same tenants.  I would probably get the leases changed to 5x5 if I can.  The other 2 shops, factory and house is to be leased back to the current freehold owner.  They are keen to stay on and a 5x5 is in principle agreed.  I thought 2.5% rent increase was rather standard for commercial.....to be honest in all the residential properties I own I'd rather have the same tenants staying on  (I manage myself as I live off my investments) so I don't increase the rents more than about 3% which I know is below the market but it keeps them happy and they look after the places......and I know them all which I know one shouldn't do ie to mix friendship with business. But for me it works well.   The 7.5% return is net as there are no outgoings but I could have it up to 8% if they agree to the offer price that I might make.
If  you were borrowing $1m to invest would you put it in commercial, residential, super or stockmarket?  In my own case I would feel uncomfortable in anything but the first 2 but maybe I need brainwashing to become more diverse.
Cheers Carpe

I'd suggest locking new commercial  leases into cpi as a minimum, recently did a few at the greater of cpi or 4% as well as retail in shopping centres at 5%. You won't get away with a ratchet on the retail leases.

I am opinionated. Take me at face value, read between the lines. The wise man only believes half of what he hears, a genius knows which half.

Are there any further improvements that can be done that will allow further rent increases eg air cons ,paint ,minor rens etc
Future tennants for building if someone leaves (Is it a strong town?) 
I personally prefer to have commercial managed by local agent .
I have found commercial tenants put much more effort into maintaining and improving "their" building than residentual.
At the end ov the day you need to be happy with deal and be able to sleep at night.

Hope it makes ya a motza.

Regards appsie

Hi Carpe
It helps to be sceptical. The owner seeking to sell on leaseback wants to get money out, while enhancing the deal by being a tenant, but for how long? Why get out ?
Tenancy pays, vacancy doesn't. Sometimes owners become sellers when they get a whiff of someone folding or wanting to leave. Landlords have more info , goss, intel, etc on their properties and existing tenants than prospective buyers.
Some leases have 2-3 yrs annual rent increases at CPI then the next one at "market rent" which allows for a higher increase if the area is prospering faster than CPI.
7% is low and as such should only be enough if the tenants are very secure stable ones, like household names.
Good luck.
Cheers
thecrest

the cosmos always delivers so order carefully

Thanks for feedback guys....all very helpful.  In terms of your comments "thecrest",  I would not purchase unless the net income is above 8% of the purchase price plus all costs.  The seller is well respected in the town and it looks they're selling the freehold as I suspect there are family reasons following the death of a key family member and I think a redistribution of the wealth among family members entitled.  It was mentioned earlier about 5 year leaseback but now some sceptism has been drawn into the situation...they want a lease arrangement of 1x1.  I'm getting a bit cold on it as one of the shops relies on the factory out the back to produce the products.  Hence, I have asked them to supply a profit and loss statement for the shop/factory business over the past 3 years at least.  It narrows who I can lease the shop/factory to later on.  Two of the shops are leased to others and they are solid with 5x5 year leases.  The shop/factory, other shop and the house leased back by the current "owner" is now looking a bit dodgy.  Great looking buildings and well maintained including the fully renovated house in a town beginning to really start moving.......but it is the factory that bothers me......it currently just makes wooden toys etc so very limited on who I get to go into the factory later.  I know I can get interest loan at under 6% at the moment so on paper it looks good at the moment but the future  is a concern especially a factory and shop for wooden toys.  So even if I manage to get better deals on the leases what do you think about taking on a shop dependent on the production from the factory?
Cheers
Carpe

You will need to make certain of the zoning and consent conditions of the factory & shop so you know who else can lease them eg general industrial zoning or is it a non-conforming use?

Speak to one of the other agents in the area (who isn't dealing with this property). How easy do they say it can be leased and what is the market rate etc?

I am opinionated. Take me at face value, read between the lines. The wise man only believes half of what he hears, a genius knows which half.

Thanks again for comments.  "Scott NO Mates" it is good advice and something I will definitely do.  If the lease backer decides to jump ship after a year would he not only do this if he 'sells" his business......it must have quite a bit of value although perhaps he can just transfer the business to another shop?  Sorry, this is probably a naive question......perhaps I don't have enough experience to enter into commercial although this is probably a relatively small commercial investment.  I'm also wondering does the capital property value of a commercial freehold increase at the same level as the surrounding residential areas?
Cheers
Carpe

If the lease expires the vendor (and tenant) can relocate, provided that there is alternative suitable premises for them, they may sell the business to someone who may want to remain or relocate or thirdly, they may simply be looking to retire/close a loss-making business.

Capital values rise and fall at different rates depending upon the category of the property. Commercial values are more closely linked to the overall status of the economy, recessions lead to discounting of rents/provision of greater incentives whereas residential property fluctuates along a roughly 7 year cycle.

Other influences also affect the value of properties regardless of the economic cycle eg rezoning proposals, major redevelopment, infrastructure proposals etc.

I am opinionated. Take me at face value, read between the lines. The wise man only believes half of what he hears, a genius knows which half.

Have you thought about getting a loan in your Super Fund to buy it - I am looking at it now?