8 Things to Consider Before You Buy Commercial Property
Last month, I made the case in 6 Reasons to Invest in Commercial Property that your long-term investment strategy should include commercial real estate. That’s a bit of a stretch for many people, because the commercial market presents some challenges that don’t exist in the residential market. The fear of the unknown causes many people to shy away from considering commercial real estate as an option.
Because you’re likely quite a few years away from living primarily on the income from your investments, you’ve got time to address your fears and change your mindset. Educate yourself now, so that when the time comes, commercial real estate is a viable option for you.
So, what makes one commercial property more valuable than another? Here’s a short list of the eight considerations to help you think more like a commercial property investor right now:
1. Quality Of The Tenant
Just as in residential property, there are good tenants and not-so-good tenants. One of the reasons investors tell me they prefer residential property is because, “people will always need homes to live in.”
This is true, although they may not need your home. Just ask anyone who bought property in a Queensland mining town two or three years ago.
While today’s business owners will always be living in homes, they may not always need a place to conduct business.
The quality of a commercial tenant comes down to this one factor: The likelihood the tenant will still operate a profitable business in the future.
The ultimate commercial tenant is therefore a blue chip company or perhaps better yet, the government. No matter what you’re renting, there’s always a vacancy risk. In commercial property, this risk is greater. If you can combine a quality tenant with a long-term lease, you’ve just locked in the two most important factors that make up a winning commercial property investment.
2. Structure Of The Lease
Commercial leases tend to be more complex and require the help of a solicitor to draw up. The structure of a commercial lease includes the following:
- Length of Rental Agreement
- Terms of Renewal
- Frequency of Rent Reviews
- Who Pays Operating Costs of the Premises
- Who is Responsible for Maintaining the Building
In residential property, the tenant is often on the winning end of these considerations. However, commercial leases tend to favor the landlord. Not only are the lease terms longer, the tenant generally pays most of the operating and maintenance costs. This, however, is not written in stone. The parties must negotiate these terms on a deal-by-deal basis.
When you’re in the market for a commercial property, keep in mind that the structure of the lease is a significant source of value. For example, which scenario would you prefer, a 20-year lease with the ATO that has annual rental reviews pegged to inflation, complete with an agreement that the tenant pays for all outgoings – or a three-year fixed lease with a mum and pop grocer who calls you every month to request a repair of something in the building?
3. Return On Investment
One of the primary selling points of any commercial property is its yield. To express this figure as a percentage, yield is the annual rental income divided by the value, or purchase price of the property, multiplied by 100.
For instance, if you pay $500,000 for a property with an annual gross income of $50,000, your yield is 10 percent.
Investors generally buy commercial properties for income first and capital growth second. The higher the yield, the more attractive the property is generally considered to be. Yield is a valuable measurement because it expresses income in relation to how much wealth is tied up in the property. We like higher yields because it means we can use less of our wealth to achieve our desired level of income.
Future yields of a property are tied to the lease structure. For instance, as the value of a property increases with inflation, the rent will also increase, if rent reviews are written into the lease. However, the yield will decrease if the property appreciates in value during an extended fixed rental period.
Go ahead and have a quick look at realcommercial.com.au. You’ll notice that they advertise many listings on the basis of their yield.
4. Desirability Of The Location
Just as in residential property, some commercial properties are more valuable than others based on where they are placed. What makes one location more desirable than another?
Visibility and accessibility are key factors in determining value. Most retail businesses depend upon being visible to drive-by and foot traffic. They also need to make sure customers can easily access them.
A petrol station that customers can only enter from one side of the street will lose business to another more conveniently-located station just down the street.
Just as in residential property, the proximity to public transport is a key factor. This comes back to the accessibility issue.
Proximity to surrounding businesses is also important for many tenants. Cafés, banks and other retail shops all attract additional clientele, which provides support for the business.
Finally, a commercial property located within a broader surrounding suburb will also attract a higher rent. In any community, there are certain parts of town that people perceive to be more favourable as a place to live, and to conduct business. This will factor in to the property’s value, as well.
5. Zoning Of The Area
The zoning of a particular area determines the present and potential future use of the property. You might feel you’ve got the perfect spot for a particular type of business, but if the local council doesn’t legally allow it, you’re out of luck.
Every state’s commercial zoning codes are different, but they generally depend upon council’s perception of the needs of the people who live or work in a particular area.
Town planners tend to keep most businesses out of residential neighbourhoods by zoning commercial areas along busy streets, or in central business districts. This helps to avoid conflicts between residential homeowners and business owners. It also makes traffic control more manageable.
When purchasing a commercial property, it’s important to be aware of the types of business uses that are permitted in the area. You will want to buy with caution if the local council doesn’t permit the existing use of the property. Or, you might find an opportunity that the previous owner may have been missed. Being aware of future zoning changes can open up additional future uses, therefore increasing the value of the property.
6. Potential To Add Value
Just as residential investors look for opportunities to add value through subdivision, development or renovation, commercial investors seek to add value in similar ways.
Steve McKnight tells the story of one of the first commercial property deals he sold to a wiser investor who saw opportunity he missed.
After the new owner took possession, he subdivided the property right down the middle. He then turned the large single retail shop front into two smaller shops that were easier to rent and increased his yield.
Additional value-add strategies to the property could include:
- Redeveloping additional space or floors for residential or commercial use.
- Renovating the exterior of the property and updating signage.
- Rezoning an industrial site.
- Increasing the rent, or extending the lease term.
When you can see value-add opportunities that others can’t see, that becomes a potential win for you in commercial property.
7. Competition In The Market
Just as in the residential market, supply and demand affects value. If you own a commercial property similar to many other properties, all competing for the same tenants, that’s a problem.
You don’t want to buy in a market that is oversaturated, or one that has a strong chance of become oversaturated in the future. Too much competition for tenants means lower rents, therefore lowering property values.
8. The Outlook Of The Economy
At the end of the day, the value of any commercial property depends on the outlook of the fundamentals of the overall economy. When times are good, many businesses thrive. When times are tough, the weakest or most inefficient players get weeded out. It’s a harsh reality, but that’s the truth.
This highlights again the most significant risk of investing in commercial property – vacancy. This is why some commercial investors shy away from retail properties.
When I was living in the States a few years ago, times were pretty tough for many businesses. Companies that people once considered to be blue chip retailers began going out of business.
I remember seeing one such empty building and wondering whether the owner was retired and if it was affecting their standard of living. I often wonder the same thing when I drive by empty commercial properties here in Australia.
Regardless of where you are in your property-investing journey, education is crucial. I’ve coached hundreds of investors in Steve McKnight’s Property Apprenticeship. Some of them were just starting out and some owned one or two residential properties, while others were professional, or high net-worth investors who were already buying commercial properties. Take a moment to pre-register for Steve’s course and let’s talk about whether the timing is right for you.