Lately we’ve been talking about the pros and cons of investing in commercial vs residential property.
Most people know something about residential property, whether it’s from buying their own home, investing in a residential property, or watching the latest series of “The Block”. But not many people have hands-on experience with commercial property, and it’s not something we’re generally taught how to buy.
We’ve spent the past two blog posts talking about the advantages of investing in commercial property lately. Now it’s time to talk about the disadvantages. Some of them are more about perception than reality, but you still need to consider them before making your final decision.
Here are four ‘disadvantages’ to choosing a commercial property as an investment.
1. The perception that it costs more to get into the commercial market
Like a lot of people, you might think the commercial market is too expensive for you to be part of it. But you may think differently (and understand the long-term benefits of owning a commercial property) once you look into funding options such as:
- using your equity (the difference between the value of your existing property and the debt you have on it)
- vendor finance (finance provided by the person selling the property)
- other creative purchasing methods (e.g. delay settlement or part vendor finance).
With commercial property you can finance 60%-70% of the value, compared to borrowing 80%-90% for residential property.
The loan-to-value ratios (LVRs)—the debt as a percentage of the value—can be a stumbling block for some investors. But using the cap rate makes it easier to prove the value of a commercial property. And banks will often lend on the valuation price of a commercial property—even if it’s greater than the contract price.
Let’s say you buy a commercial property for $300,000 and you get a tenant. If the cap rates in the area put the value at $350,000, you’ll have a strong case for the bank to lend you the money based on the valuation. (I’ve had valuations increase as much as 30% in a matter of months because of either a rental increase or a totally new lease.)
Of course, the banks seem to be moving the goal posts constantly these days. But that’s okay—we have a good broker who will handle all of that for you.
This is all quite different to the residential property market, where banks generally lend the lower of either:
- the contract price (the negotiated price on the contract for sale)
- the valuation (the value calculated by a licensed valuer).
So if you buy a residential property at $300,000, but the bank valuation says it’s worth $350,000, the bank will probably still only lend you money on the $300,000 despite the valuation figure being higher. If you hang onto it for a while, or perhaps renovate it, you may be able to prove the property really is worth the $350,000. But in the current market that could take years.
That’s the beauty of commercial property. Its real estate value is generally based on the income it produces, which makes it much easier to understand.
But if you still think commercial property is out of your financial reach, consider this: The entry level for commercial property can be as low as $80,000. You can even buy an office suite in Sydney for as little as $200,000.
2. The perception that commercial leases are more complex
Another big assumption is that commercial leases are far more complex than a residential lease, making them too difficult for the average property investor to deal with.
In the past that may well have been the case. Some of the early commercial property owners have confusing (and even conflicting) clauses in their leases, possibly from being drawn up by inexperienced solicitors. But leases are largely standardised these days (apart from variations between states), and written in plain English so they’re easier to understand.
That being said, I highly recommend engaging a solicitor in whatever state you’re buying in. They’ll be up to date with the state’s Tenancy Act, and help protect your interests.
Each state has fantastic retail tenancy guides (written in plain English) for both tenants and landlords. This is very important, because from my experience the clearer the lease is, the easier it is for you to manage the property. (You can find links to the information on the business.gov.au website).
A basic knowledge of the standard lease formats will help you during negotiations with the prospective tenant. But don’t worry—your solicitor will handle all the details for you.
3. Perceived lack of capital gain in commercial property
We’ve all heard the stories of people making a killing when the value of their residential property increased dramatically in just a few years. You may have even made one yourself. But things have changed since the GFC, and I believe it will now be a lot more difficult to achieve high capital gains with residential property.
However, commercial property is numbers driven, making it far easier to see (and prove) what it could be worth in the future. It may not be as exciting as investing in residential property, but it’s certainly a lot safer.
A well-selected commercial property should give you a more regular income stream than residential property, as well as a capital gain should you decide to sell down the track. In today’s economy it’s all about cash flow, and how much you can put in your pocket every month.
4. Retail spending is down
This is the one disadvantage that isn’t based solely on perception. In the past year or so a number of retail areas have experienced a downturn—some due to increased online spending and others due to a general economic downturn in their sector.
However, I must point out that it’s not affecting all areas of commercial property. If you take the necessary steps when performing due diligence on a property, you should be able to avoid any problem tenants. And there will always be a retail market for all types of products.
Despite these ‘disadvantages’, commercial property should be in every property investor’s portfolio. Once you get involved in the commercial market you’ll see the fantastic benefits it can bring. You may even want to convert part of your residential portfolio into commercial down the track.
Your goal is to find the right property, get it running properly, get paid regularly and have large upsides from the property. A well-selected commercial property will help you do that, and give you a great passive income that should increase each year.