In our previous blog post we talked about investment properties, and gave you five advantages to choosing a commercial property over a residential one. Well, here are five more advantages to investing in a commercial property.
1. They’re easier to manage
Commercial properties are a lot easier to manage. Once the lease is in place, all you or your property manager need to do is follow it to the letter. A typical lease covers all issues including repairs, payment of outgoings, rent increases, etc.
And while it may take a little longer to secure a tenant for your commercial property compared to a residential property, you’ll be signing them up for years, not months.
2. You can easily add value and supercharge your investment
With a tenant signed up for a long-term lease, you’ll probably get the opportunity to build on your investment—literally.
After a few years your tenant may ask you to do something to the property, such as create a new shop front or install air conditioning. And as you’ll see in our example, it could benefit you as much as it does your tenant.
Let’s say the tenant asks you to put in a new shopfront for their café. They believe the current one is holding back their business because it restricts the flow from inside to the outside tables. But as much as it will make the café more attractive (and thus increase their turnover), they want you to pay for it instead of spending their own money. So you make a deal: you’ll pay for the $10,000 upgrade if they’ll agree to a $1,200 a year increase in their rent to cover the cost, which they do.
So they’re now paying 12% of the $10,000 upgrade price. But it’s only costing you 7.1% (the loan rate) to borrow that money. And now that you’ve increased the rent the value of the property has also increased according to the cap rate formula.
You’re happy because you now have a more valuable property and can charge more rent. And your tenant is happy because they got their shopfront upgraded without having to pay for it.
Another potential upside is creating more lettable space (i.e. usable space that can be rented) and using it in other ways, such as leasing space in the front window for an ATM. You’ll get extra rent, and the tenant gets more customers coming to their shop to use the machine.
3. You’re buying a lease
This is perhaps the biggest advantage of investing in a commercial property.
You’re effectively buying a lease that guarantees you an income. It will clearly set out the terms and conditions of the tenancy, how you’ll get paid, when increases will happen, and how they’ll be calculated.
And with your tenants running the business to generate their income, they’ll be eager to follow its terms by paying their rent and outgoings on time.
What’s more, they’ll probably want to sign a long-term lease because it plays such an important part in their business. Let’s say they decide to sell their business. They’ll need a long lease so they can offer it to potential buyers. (Not many people will be interested in a business with only one year left on the lease, especially if they’re paying a lot of money for it.)
Chances are the tenant will say, “I want to sell my cafe, but I’ve only got four years left on the lease. Can I get a new five-plus-five lease?” (A ‘five-plus-five’ lease is a five-year lease with the option of another five years.)
You win because you now have a ten-year lease in place. And the tenant wins because they can offer a ten-year lease with their business, which increases its sale value.
And if they do sell their business, they have to guarantee the new tenants will pay the rent for the balance of the lease, further protecting your interests. Of course, it all depends on the lease you have (it’s covered in the assignment clauses), but your solicitor can advise you on this.
Your lease may even specify that the tenants have to maintain everything inside the building (and possibly the outside as well). For those of you who’ve had to pay for the maintenance of residential properties, this will be a welcome relief.
4. It’s easy to project future cash flow
Because commercial property values are based on the numbers (i.e. the rent), it’s easy to know what the value of your property will be in one, five, ten or even twenty years’ time.
You can work out what the increases will be from how much the CPI increases each year. Your lease may even specify fixed increases, making it even easier to project its value.
It’s a far cry from residential properties where downturns in the market can affect rent value much more quickly, and emotion-based buyer and tenant decisions can make it difficult to project cash flow.
5. Most of the costs are covered by the tenant and the tax office
The Australian Taxation Office (ATO) lets property investors offset any income losses (where property costs are higher than property income) they incur from their investment property against other income. Conversely, when a property is cash flow positive (which should be your aim), you may need to pay tax on the positive income. We recommend talking to your accountant to minimise the amount of the tax you have to pay (if any).
Note: The amounts will vary depending on your taxable income, etc.
If the property is producing positive cash flow (i.e. the income is more than the property’s interest and running costs), the tenant is paying all of the costs of owning the property.
If the deal stacks up on a rent return basis, your bottom line cash flow will be improved by depreciation, etc.
And when the income is more than the property’s interest and running costs, the tenant is paying all of those costs.
All up, we’ve now given you ten advantages to investing in a commercial property. And based on those advantages, it may seem like the perfect investment opportunity. But it does come with some disadvantages as well, and we’ll be telling you all about them in our next blog post.