High returns, stability, lots of options – different kind of property luring loads of investors
Years of pandemic followed by months of rate rises have lured a flood of residential property investors into the commercial space for the first time — and for good reason.
But you can easily make mistakes if you don’t know what you’re doing, experts say.
Since 2020, commercial investors have been battling for essential service assets with long-term tenants. Think industrial warehouses, childcare centres, petrol stations, medical clinics and fast-food outlets.
Amid stockmarket volatility and uncertainty in the housing market, those who’d otherwise chase residential assets are now looking to a different type of investment.
PropTrack data seems to prove the trend. Investors’ share of total housing purchases fell from about 15% in late 2018 to just 5% at the end of 2022. At the same time investors now account for more than a quarter of all housing sales.
PropTrack economist Anne Flaherty said the lure of commercial real estate is clear.
“To date, commercial real estate values have been more resilient and less impacted by the rising cost of debt than residential values,” Ms Flaherty said.
“And commercial real estate assets typically offer higher yields in comparison to residential.”
Burgess Rawson’s commercial portfolio auctions are a good litmus test of the market and its February sales cleared 29 out of 30 properties.
The firm’s chief executive officer Ingrid Filmer said there’s been “an absolute flight” of residential real estate investors moving into commercial since the start of the pandemic.
“They’re from all walks of life. I’ve got small business owners, tradies, immigrants – everyone,” Ms Filmer said. “There’s a perception that commercial property is bought by rich people. That’s not the case.”
Benefits of investing in commercial property
Commercial properties are more likely to be positively geared, they can make a better return, and their lease terms can provide a more predictable income stream, Ms Filmer said.
“Often the tenant of a residential property only has to sign a one-year lease and pay a one-month bond,” she said.
“With commercial properties, the leases are up to five years, your tenant often pays the outgoings, and you can have a three- or six-month bond in case something goes wrong. It’s more of a set-and-forget investment.”
Investors can also depreciate commercial property, while they can only depreciate a residential property that’s brand new or bought off the plan.
Michael Gilbert, partner of national portfolio investments at Knight Frank, said the longer leases associated with commercial property, which often include fixed annual rent increases, are attracting lots of investors seeking stable assets.
“We are seeing many first-time commercial investors in the market,” Mr Gilbert said.
“These are sometimes mum and dad investors, but at the moment we are seeing many buyers who are nearing retirement and looking for a stable income for when they stop working full time.”
Ms Filmer said commercial tenants tend to be reliable, or “sticky”.
“They’ve put a lot of money into the fit out. Fast food tenants may have installed exhaust fans, cool rooms, and counters. A dental clinic may have X-ray equipment, medical chairs, and reinforced concrete.
“They can’t just move next door. And people take confidence in the capital improvement the tenant has invested in the property.”
But while you may have a commercial tenant for longer, they can also be harder to replace, Mr Gilbert cautioned.
It’s also worth noting that commercial property buyers need more cash up front for a deposit. While you can borrow 80% of the property value in residential, this number slips to 65% to 70% with commercial property.
Will the good times last?
While commercial property values have shown more resilience throughout the pandemic, yields have started to soften across most asset classes since the second half of 2022, with this trend expected to continue, Ms Flaherty said.
“With further interest rates likely over the coming months, we are likely to see yields soften further over 2023.
“However, well located assets occupied by high-calibre tenants will continue to see strong levels of demand, particularly in light of more challenging economic conditions.”
Because it’s hard to compare different commercial properties like for like, they are measured in yields.
These are calculated by dividing the annual rent (gross or net) by the purchase price, so a property with a rent of $30,000 per annum divided by a purchase price of $500,000 would show a yield of 6%.
When property prices increase, yields reduce or “harden”; when prices go down, yields increase or “soften”. So, while vendors seek low yields, buyers seek high or softening yields.
Mr Gilbert said while rapidly rising rents are pushing up yields for residential investors, commercial property yields are still around double.
But, as with any investment, it’s important to know what to look for.
The best deals around
First-time commercial investors typically start off in a smaller price bracket, with an entry point of around $1.5 million to $2 million.
In Sydney, this budget would buy a small retail office, cafe, medical clinic or industrial unit, with regional areas offering lower purchase prices and often solid growth prospects.
Different asset types carry different vacancy risk, Ms Flaherty said.
“For investors seeking defensive income, assets occupied by tenants operating in relatively recession-proof industries could be a good option.
“Examples include healthcare, childcare, service stations, and non-discretionary retailers such as grocery stores. Strip retail and office, in comparison, typically see a higher vacancy risk.”
Investors should also assess the lease terms.
This means the quality of any existing tenants, how long they have left on their lease, whether fixed or inflation-tracking rent increases will take place, whether they pay the outgoings and, if not, by how much they’re expected to increase.
Some investors will be willing to take on more risk than others, Ms Flaherty added.
“An investor needs to be clear on whether their strategy is to achieve high income, in which case they may be willing to tolerate investing in higher-risk assets, or whether they want defensive income, in which case their return will typically be lower.”