Special Challenges In Commercial Property Investment - February 2022
February 7, 2022 / Written by Rich Harvey
One interesting development I’ve spotted in today’s market is increased interest in commercial property among everyday residential investors. The stars are aligning in the sector after it faced exceptional challenges at the start of 2020.
But rather than being swallowed up by the pandemic and its shutdowns, the role of COVID for commercial real estate has been more of a filter. It’s highlighted resilient businesses and tenants and brought to the fore assets that can survive and thrive. Things like adaptable floor spaces, proximity to population for easy shipping, and the ability to socially distance workers and customers.
In addition, the fast growth of residential property values is making it tough to get decent rental returns. As purchase prices rise, yields tighten.
Commercial property can be the remedy for this low return, but here’s the caveat – to do well in the commercial investment space you (or your advisor) must understand its unique challenges. Fail to do this, and you could make a very costly mistake.
Here are some nuances around commercial property investment you must be aware of.
The lease is EVERYTHING!
A property’s lease is the key to its value. Unless your investment is tenanted and generating a reasonable rental income, its value is severely dented.
A vacant property requires it’s to take on the risk of finding a tenant, negotiating a lease and having the building managed, so it is far less valuable than a holding with a tenant in place.
It’s no good thinking you’ve landed the deal of the century because you bought a low-priced vacant freestanding shop in outer Newcastle, only to discover no business can viably trade in that space. You simply won’t find a tenant, so now all you have is an expensive, empty box and more mortgage repayments.
But it’s not enough just to have a lease in place.
If a property already has a tenant when you purchase that’s a good thing, but you must fully understand the tenant’s operation and consider their viability. Will their business model be sustainable? What are the risks of their closure (which will end the lease)? Are they likely to renew?
Also, with leases – the devil is in the details, so your advisor must understand lease fundamentals. What’s the renewal terms? How are rent increases calculated? More importantly in the current market, how did pandemic legislation impact the lease arrangements, and will there be long-term fallout from this?
The lease is the lynchpin. Make sure you’re across it.
Loan arrangements for commercial property differ from residential.
For starters, interest rates on commercial property tend to be higher. If your tenant goes bust and the lease ends early, the financier will be left holding security that’s far less valuable than the loan it’s securing. To compensate, banks factor in extra percentage points to cover the risk.
This is also why commercial loans run for shorter borrowing periods than residential loans. While you might secure a 15-year loan term, some will run for far less. In addition, revaluations of your asset and renewal of the conditions may occur every one to five years. This means your commercial investment’s value is potentially being scrutinised up to 30 times more frequently than your home’s value.
Why? Again, because tenancy is key with commercial, the bank wants to check the security of that tenancy at frequent intervals.
Finally, loan-to-value ratios (LVR) are normally lower for commercial. Unlike residential loans where you might get an 80 to 95 per cent LVR, commercial property is more likely to be at 60 to 80 per cent LVR. As such, you’ll need a larger deposit (or more security) when buying.
Asset selection is crucial
Like residential, the asset you choose will determine its long-term success, but the fundamentals around property selection are different for commercial. Characteristics like exposure, parking and delivery accessibility come into play.
You might also need to think about flexible floor areas. How adaptable and changeable is the space? For mum-and-dad style investors, commercial assets that can potentially accommodate multiple uses tend to be less risky. Unless you have speciality knowledge around childcare center's, service stations or fast food outlets, then it’s tough to successfully invest in those spaces. Instead, seek a property that could operate easily as, say, a hipster café, boutique clothing outlet, band venue or gaming company. Vacancies are a death nell for a property’s value. By having an adaptable commercial property, you will appeal to a wider range of potential tenants, and that makes your asset less risky and more attractive to future buyers.
Commercial investment has terrific potential in the current market, but only if you make wise decisions. If you are considering buying a commercial asset, its imperative to use a specialist advisor who will work in your best interests. A buyers’ agent with skills in the commercial space is an absolute must for less risk and more reward.
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