If you’re thinking of investing in commercial property as a way to diversify your portfolio, be sure to understand the risks.
If you didn’t know already, the commercial space is quite different to residential real estate: you can earn a much higher return but there are also greater risks entailed.
Commercial properties are exposed to economic fluctuations
Economic downturns can influence the residential property market, just like its commercial counterpart, but it is commercial property sales that got the most spectacular hit when that occurs.
By way of instance, when the economy slows and unemployment rate goes up, consumer spending goes down. People have a tendency to spend less on discretionary spending.
The first industry generally seems to be changed during the periods is the retail industry as well pubs and restaurants.
Followed closely behind this are transportation and distribution and manufacturing companies. As a result, the values of warehouses and even geotechnical engineering factories start to fall as vacancy rates increase.
The reason is straightforward: if Australians are not spending money, companies won’t be inclined to grow or expand into the new commercial premises.
The fundamentals of the area could change for the worse. When Searching for a commercial property, you need to think about:
- Accessibility to transport links
- Proximity to companies that will help support the businesses of your potential tenants such as transportation companies and wholesalers.
Where property investors that are new the commercial market fail is exploring and going into the future.
By way of instance, while the place today may be only right for the office space you want to buy, it is frequently an afterthought to test out what the local council has planned in the not too distant future.
Wait, is the development infrastructure construction projects including train lines, retail centres and motorways not a good thing for commercial real estate investors?
Yes they are, but only if it’s happening in your area!
If these kind of jobs are happening elsewhere, it has the capability to draw potential tenants away from the premises.
It’s hard to get a true market valuation
One of the main tools used by valuers when doing a property valuation is the capitalisation rate (cap rate).
The problem of trying to ascertain the possible return on investment to your commercial property functions on the assumption that revenue estimates for businesses are accurate and that the market value of the property will remain unchanged.
It’s also tough to back up a market value estimate with similar sales since you may be unable to find 2 or 3 of precisely the exact same property type in the region to compare to. This a unique problem in the industrial housing market.
It’s costly to maintain a commercial property
Among the wonderful things about commercial properties is that many of the outgoings such as council rates, insurance, repairs and maintenance are covered by the lessee.
But, it is still important to think about the age and condition of the building structure before committing to the investment.
Some buildings need love
The building should be structurally-sound and possess the flexibility to modify the interior layout easily to suit all kinds of businesses. A good example of such building could be corporate event venues you can find in Melbourne. These buildings are designed to accommodate different types of events from different kinds of businesses so versatility is of utmost importance.
Are these prices not for the tenant?
Technically, they are, nevertheless, you also have to think about whether it will entice companies that are looking to set up store.
You may have to pump in a number of your own money to get the building up to scratch.
For Licensed commercial properties such as child care centers and aged care centers which have strict building codes made to minimise health and safety problems, the prices can be in the tens of thousands.
Other examples include chemical treatment centres and medical centres and also the may require special council approval in order to operate for their intended purpose.
At the minimum, you might need to help pay part of those fit-out costs simply to have the tenant to sign on.
High Price of entry
Compared to residential property, commercial properties can relatively more expensive, particularly when it comes to retail and office space near the CBD.
Industrial property can also be expensive, though they’re generally not found in prime CBD locations. It’s more to do with the size of their house.
This in itself presents a double whammy of sorts as larger commercial properties could be more difficult to market that little office and retail suites.
Not a risk, per se, but it’s essential to say that the goods and services tax (GST) applies to the cost, lease received and any expenses in relation to the property.
Higher risk of long term vacancies
Among the unpleasant realities when it comes to commercial real estate is that you’re tied to the tenant — they are not tied to you personally.
Depending on the financial environment and the level of competition in the area, you are constantly trying to”acquire” tenants as though you were a company owner.
Commercial real estate risks really don’t come much larger than vacancy rates.
For a warehouse, factory or other industrial property, you could be waiting for several months and even up to a year to find another tenant.
Compare this to 1-2 weeks for a residential property!
The worth of commercial properties is very closely linked to the lease so if the premises become empty, or the rental is going to expire, the house value falls quite dramatically, normally.
Obviously, this alone presents a chance to get a fantastic price on a property in the understanding that you’ve done your research on market trends and expect the particular sector, while it’s office, industrial or retail, to turn around soon.
Making a solid offer
If it comes to residential investment properties, the worst case scenario is that you just fall weekly lease with a few dollars if you can not seem to find a tenant.
You must do far more than that with commercial properties such as offering rent-free intervals (occasionally up to 6 months) and agreeing to part-fund funding works and fit-out costs.
The major risk here is that you are altering the lease term for a customer that will either go out of business in the next couple of years or simply move to a new site.
The way to lower your risks when investing in commercial property
- In the end, the best thing you can do if it comes to reducing the effect of commercial property risks is to take a hands-on strategy when undertaking your own due diligence.
- Read marketplace reports and be educated when it comes to business tendencies. There’s plenty of advice out there.
- Obviously, separating white noise from truth can be difficult if you do not have a group of experts to encourage you, such as:
- A commercial mortgage broker who can help you secure a commercial property loan that it is competitively priced and best suits your investment needs.
- A solicitor that specialises in commercial property purchases and will help ensure that heads of agreement is in your best interests when purchasing the property from the seller, as well as drafting up the lease arrangement with your lessee.
- A commercial buyers agent who will e you to source a quality tenant and negotiate the rental term to win them.
- A property manager who can help you manage your renters, ensuring rent is paid on time and keeping you advised of any modifications the lessee would like to make to the property.
Any tips for reducing commercial real estate risks?
- If you’re just starting out, consider purchasing smaller, standalone retail shops or buildings which are strata title instead of large commercial property such as the Melbourne city conference centre.
- When building a commercial portfolio, be wary of being overly heavily-weighted in certain property types.
- Avoid purchasing a multi-tenanted block of components because the vacancy risk is considerable.
- Learn to identify opportunities by taking a risk, for example, an office block may not be worth much at the moment; however, a new freeway structure could see the real estate value skyrocket.
- Make certain the lease agreement is right and you understand just what your rights and responsibility are. Your solicitor and a buyers agent can help you to negotiate a lease that is reasonable for you but will not put off any potential tenants.
- Keep an eye out for infrastructure projects that are going ahead in the upcoming few years. What type of company will they attract and do they fit the commercial real estate you’re seeking to invest in?
- Infrastructure jobs go together with the rollout of new suburbs, which also presents opportunities for child care centres as well as the demand for aged care and healthcare facilities. As more families move in, it makes sense to invest in tiny offices in the area to coordinate with the desire of individuals to work nearer to home. Additionally, it pushes up demand for shopping centres, retail stores and cafes.
- Inspection your tenants carefully including their fiscal strength. Ideally, you will want to aim for so-called”blue chips” which are corporate and government tenants.
- You might need to offer a longer lease duration so as to attract more prospective tenants.
- Do some research and look in places where lessees are paying under market rental. This will allow for advancement in the quality of tenants with time. This can help attract buyers that would like to pay a premium for the property when you finally decide to sell it to get capital profit.
- Look into different ways that you could increase your commercial property value to attract tenants and potential buyers cheaply.