What to consider before buying a commercial property?

Buying a commercial property may seem like a daunting task, however, if the numbers make sense and you’re prepared for the long game, then the principles are much the same as buying a residential property. Now, that’s not to say building a commercial property portfolio is easy, or that it doesn’t come with it’s added level of risk, but like any investment opportunity, if the numbers stack up and thorough research is conducted, the risk could end up being very rewarding.

So firstly, you do not need to be a business or in business yourself to invest in commercial property, but you do need to understand the target market of the property you are purchasing or the market in which you want to tenant your property with. If you buy a property with a commercial tenant already attached, spend the time researching the business that the tenant is in. Understand the viability of the business and the quality of the lease, take notice of local amenities and proximity to local transport, also assess the level of difficulty it would be to convert the property for different tenant needs, understanding all of this (and more) will help uncover whether the property is, and continues to be, a sound investment. Remember, unlike a residential property, trying to replace a tenant or even sell the property is much harder and takes a lot longer. However, if done right, and you manage to secure the desired tenant for the long term, you could start to see your commercial property really working for you by producing a healthy, regular income stream for the foreseeable future.

 

The advantages of investing in commercial property

• Higher income opportunity, and improved cashflow – unlike the average 3-4% rental income offered by residential properties, commercial properties tend to be higher, typically between 5-12%, which means, depending on how the loan is structured, you could find yourself with an investment that is positively geared or cash flow positive;
• Annual rent increases – to further reinforce the income advantage, commercial lease agreements typically have fixed rental increases built into the terms of the contract;
• Longer lease terms;
• Expenses and upkeep are usually funded by the tenant – unlike a residential property investment, tenants under a commercial arrangement usually fund all of the day-to-day expenses of the property, i.e. council rates, land taxes, insurance, maintenance and repairs. This also means commercial tenants tend to keep the property in good shape.
• It can be a tax-effective investment – depending on the entity structure you choose to purchase a commercial property (i.e. under a company, through a trust, within a self-managed super fund, or a partnership), and coupled with the broad scope of depreciation you could claim, you may be entitled to significant levels of tax benefits. We suggest talking to a qualified solicitor, accountant and/or financial adviser before making any decisions based on you tax position or outcome, we are not qualified to give this advice and the information presented above is general in nature and does not take into account any personal circumstances.

 

The disadvantages of investing in commercial property

• Prone to greater market sensitivity – the nature of any business is the demand for goods and/or services, therefore any change in the economic cycle that disrupts that dynamic could have a severe impact on your commercial property. It’s for this reason, as an investor, it makes sense to keep your finger on the pulse and understand how the economy is performing and the impact it will have on the tenants leasing your property;
• Increased vacancy periods – unlike residential property, which is usually quicker to turnover tenants, commercial property (generally) isn’t. You’ll need to be prepared to service the loan and all outgoings for the property should you endure extended vacancy periods, all while covering the costs of fixing up the property and preparing it for the next tenant (which is why finding a property that can cater for different types of businesses is crucial during your research phase, this can help reduce the vacancy periods).
• Expensive to repair and renovate – following on from the point above, repairing and/or renovating a commercial property while it is untenanted is a lot more expensive than doing the same for a residential property. This is especially true if the previous tenant left the property in a sub-par condition or they had extensive fit outs done throughout the course of their lease which you now have to dismantle or demolish;
• Leasing agreements are more complex – unlike residential agreements, which are fairly standard, commercial agreements can be prone to lots of negotiation and significant variation, which means you may need to employ the services of an accountant and lawyer for assistance.

What can be used as security against the commercial property?

Fortunately, there a several options available to you.

You can consider using either your principal place of residence, another residential property you might own, or, the commercial premises itself that you intend on purchasing. The key here is understanding the impact of using a residential property vs a commercial property as collateral to secure against the loan.

One of the disadvantages of owning commercial property, which we didn’t mention above, are the more stringent finance terms lenders place on you as the borrower. Lenders generally perceive commercial loans as a higher risk investment and therefore typically require a larger deposit (sometimes up to 30-40%), coupled with a higher interest rate (compared to residential loans) and higher administration fees. On the flip side, lending has evolved so much so that you could consider using a residential loan for commercial purposes, again, only if there is capacity and the numbers make sense.

The advantages of using your home or residential property, as security against your commercial purchase, means you can access a lower interest rate, pay fewer fees and even borrow up to 100% of the property’s value. In addition, if your home or residential property has the capacity to do so, you could consider using the available equity as your deposit rather than having to save up cash. These, and other benefits, could make servicing a residential loan for commercial purposes much cheaper, just be careful not to over commit and run the risk of defaulting on any of your loans, especially if you’re using your home as collateral.

Whilst commercial loans have evolved over the years, there was a time when lenders would only lend up to 65% of the commercial property value, the loan term would be no more than 5 years and they would charge exorbitant fees due to the level of risk commercial property presented. Nowadays, lenders are more inclined to ease their LVR levels to around 80% and even extend their loan terms to 15, 20 and even 25 years. However, don’t be fooled, their appetite for this level of risk still remains the same, which is why you’ll find most commercial loans tend to be funded with an interest rate based on their ‘risk adjustment’ factors. The simplest way to look at it is, the greater the risk for the lender to lend to you and/or a higher LVR, the higher the interest rate you will be charged.

To sum it all up

1. Do your research;
2. Use the people and resources available to you, you don’t need to go at this alone, there are experts who can help at every turn of this journey (i.e. financial planners, accountants, lawyers, etc);
3. Plan for the worst-case scenario, make sure you have enough funding, make sure you can service the lending even when the property is untenanted;
4. Don’t go for an untenanted property. Even if you you’re getting it for a steal, chances are there’s a reason for that. Begin your commercial property journey as hassle free as possible, and buying one which is tenanted with a long lease or recently renewed lease will get you off on the right foot.
5. Don’t get lured in by advertising. Crunch the numbers, don’t be fooled with advertised rates, research other businesses and properties in the area. Goes back to point 1, research.
6. Don’t rush the decision. Unlike residential property, if you jump in too quick it’s a lot slower to undo and the risks will end up outweighing the reward;
7. Don’t be afraid to look out

If you’d like help finding the right lending solution to fund your first or next commercial property, please contact us, we’d love to hear from you, and help make this journey a dream.