More than warehouses: Understanding commercial property

Despite our many years of investing experience, it has taken us a long time to understand what commercial property is and isn't.

There's no point in investing your hard-earned money if you don't really "get" how it works and how you can make money from it.

So let's dive right in so you can really appreciate what we love so much about this investment vehicle.

What is it

Commercial property can be defined as any property that is zoned or used solely for business purposes. It includes shopping centres, strip malls, hotels, retail stores, warehouses, restaurants, industrial spaces, farms, office buildings, childcare centres, service stations, data centres, even vacant lots that have been designated as commercial by the local government.

They are the buildings you see every day as you walk around your neighbourhood. Just as everyone needs a place to live, most of us need a place to work.

You can't build a business on a residential property or a home on a commercial property. This is because owners or builders of commercial properties must meet certain standards when constructing a business, from the style and specifications of the building to the number of parking spaces provided. Councils also have different zoning and  regulations that must be adhered to. They also might have different tax rates compared with other types of properties.

Commercial properties can be divided into categories. There are hundreds of different options available, and choosing the right property and then the right tenant is often the most difficult part of starting your investing journey.

The key asset types are:

Industrial

These properties include heavy manufacturing, light assembly and warehousing. They are used to manufacture, process or store goods  and include factories, workshops and research facilities. Industrial properties can range in size from a small workshop of 50sq m up to facilities of 200,000sqm or more.

They generally provide higher yields than retail or other commercial investments, and also have longer lease periods due to the specialised nature and fitout of the facilities required by tenants. In most cases they are the cheapest type of commercial property per square metre. They're usually relatively large and have often been reconfigured to accommodate heavy machinery. Frequently their location is chosen for easy highway access. They may include office space, too.

Often the specialised and extensive nature of these fitouts can make it costly for industrial tenants to move properties. Generally, the larger the asset size, the smaller the tenant pool you have to choose from. But the benefit of larger warehouses is that the tenant needs to spend more money to move, which is likely to attract longer-term tenants.

For example, a 20,000sqm warehouse might attract a global logistics company. It will likely need to spend millions on fitting out the property so won't want to move on unless really necessary.

On the other hand, the smaller the asset size, the larger the pool of tenants to choose from, so it can be easier to find a tenant.
Industrial leases generally run from two to 10 years, but most sit in the three- to five-year range.

Retail

Retail properties are the sorts of commercial property that most people will be most familiar with because we see and visit these businesses all the time. Used mainly to promote and sell consumer goods and services, they include supermarkets, department stores, specialty shops, convenience stores, pharmacies, hairdressers, hardware stores, liquor shops, food takeaways, discount stores, and so on.

They range widely in size and may be home to one or hundreds of individual stores and businesses.

Retail properties can be divided into two types:

• Discretionary spend reliant. These types of properties are subject to shifts in consumer confidence and the wider economic climate, which means retail property owners often struggle with extended vacancy periods if the economy is not performing well. They include travel agents, fashion stores, high-end restaurants and electronic goods stores.
• Non-discretionary spend reliant. These types of properties tend to perform consistently regardless of consumer confidence and wider economic performance. They include, for example, supermarkets, allied medical shopfronts, fast food outlets and hardware stores.

Retail leases generally vary from 12 months to 10 years, but most sit in the three-to five-year range.

Office

Office properties are found in both urban and suburban areas. Many of us work in them, so they're easy to identify. In large cities, they're typically found in high-rise buildings in the inner-city central business district, although many cities have smaller satellite CBDs in the form of business office parks or office campuses. Office properties are typically used by professional service providers.

One advantage of office investing is that you are most often dealing with quality professional tenants. These may include global accounting firms, legal practices or government departments.

The downside of office investing is the sign-on costs. To encourage tenants to sign a long-term lease, office owners often need to offer incentives, which can take the form of a period of free rent, allowances for fitouts, air-conditioning reconfiguration and internet services.

Incentives are a result of you needing to compete hard to secure a tenant, as they usually have a lot of options open to them, especially in the CBD. This sector of the market was hit hardest by the pandemic as businesses chose flexible work-at-home arrangements to protect their employees from the virus. However, offices in suburban areas tended to perform better as social distancing requirements had less impact on smaller office blocks that were less dependent on lifts and less affected by public transport constraints.

Office leases, like retail, generally vary from 12 months to 10 years, but most sit in the two- to five-year range.

Boarding houses

A boarding house is defined as a house in which individual rooms are let out to short-term tenants, who share common areas such as kitchens, living rooms and often bathrooms.

This classification does not include backpacker accommodation, group homes, hotels or motels, seniors' housing or serviced apartments. Given the multi-income nature of the investment, boarding houses can offer a comfortable transition for residential investors seeking cash flow returns on a commercial scale.

Keep in mind that this type of investment requires extensive and constant management owing to the transient nature of the tenant population. While the returns may look good on paper, they can be severely diminished by the extra maintenance, management costs and vacancy issues. Other types of commercial property will typically generate better returns than a boarding house.

Boarding house leases generally vary from one to 12 months, but average around six months.

Unit blocks

A block of more than four units on one title can be classed as a commercial property. For years, banks have treated blocks of four or more units on one title as qualifying for a commercial loan, which increases the minimum deposit to about 30%. The yields are higher than for standard single-occupancy residential properties, given the multiple incomes involved.

As with boarding houses, you will need to account for extra management and maintenance costs. A big difference, though, is that the units are fully self-contained, so they tend to attract longer-term tenants.

Unit blocks can often allow value-add plays such as strata titling, which involves changing the ownership structure of the building so you can turn a single title into a title on each unit. This means you can sell off the units individually, potentially at a higher per-square-metre rate.

Unit leases, like most standard residential agreements, are generally six or 12 months.

Land

Land zoned for commercial property typically falls into three categories: brownfield, which is land once zoned for industrial use and may be impaired; infill, which is land that has been developed but is now vacant; and greenfield, which is completely undeveloped land.

Land can be a useful investment if you are an owner-occupier looking to build premises for your business, mainly because you can build to your own specs, laying out everything exactly as you wish.

In most cases there will be no holding income on vacant land, which rules it out for most investors. However, there are many examples where vacant land can be leased.

For example, if you own land near a port, a logistics company may lease it to store shipping containers. In that case, rent will be payable, but at a lower rate per square metre than if it had a secure building.

Large-format retail properties

This sector is typically represented by homemaker-type tenants as well as tenants previously represented in traditional department stores. Large-format retail now comprises a whopping 35% of all retail floor space. Many of these properties are freestanding or part of a larger complex.

With this type of asset, you can expect long leases - three to 10 years in most cases - and tenants are very "sticky" once they are established. Prices start from around $2million for standalone retail stores selling products such as furniture, floor coverings and other homemaker-type goods. Complexes are generally purchased by institutional investors, as prices are often more than $20million.

Special purpose

Most other types of commercial property fall into the special purpose category.

This includes such things as car washes, self-storage buildings, theme parks, nursing homes, churches and marinas.

One of the most well-known special purpose properties is service stations. These are classed as special purpose as they have a single use.

Leases can be from five to 15 years and yields can be relatively favourable, too. However, there are many things to consider before jumping into a fuel station asset, such as contamination and equipment maintenance. The key here is to know exactly what you are purchasing.

Mixed-use properties

These typically involve a shopfront with a residential unit upstairs. This provides the tenant with the opportunity to work and live in the same location. There's also the opportunity to rent out the unit separately in a multi-income scenario.

Something to consider is that they generally produce a lower yield because of the residential component. As residential yields are lower, the residential floor space will bring down the overall net yield.

They can also be located in relatively expensive metro areas, where there's a lot of competition. This means vacancies can last longer and the unit may not be as desirable to live in as a unit in a residential area, because it's located on a main road with other commercial properties. Prices for these properties generally start from $1million.

It's important always to purchase the property for its leasable qualities first, before considering the strength of the tenant. One trick we always apply to asset selection is to make sure you plan for a future vacancy. If you have confidence you will find a replacement tenant in a short period, then you have a quality property. If you are buying a property just because of a good tenant, this is going to put you at potential risk. Because what happens if that great tenant leaves and you're left with a long vacancy?

It's worth remembering that with commercial property you're interested in owning the property, not the business. The business has nothing to do with it, although it does play a part in the property selection and tenant   process, because the right type of business with a secure, reliable tenant will help the longer-term performance of your asset.

What commercial property isn't

You know the story. A couple at auction keep bidding and push up the price. They have their hearts set on their "forever home". They end up paying 20% more than they had budgeted for, against another couple doing the same thing.

Say goodbye to the emotional pull of the heartstrings and the stress associated with buying residential property, because in commercial property the transaction revolves solely around cold, hard numbers and contracts, not people - and not emotion.

Another thing it isn't is completely unpredictable. By that we mean there is more certainty over tenants and the consistency of cash flow and even growth. Let's break this down.

Things are often a lot more predictable when dealing with commercial than with residential tenants. For example, one of the most significant reasons we were drawn away from the residential property market was inconsistency of net income, mostly because you are responsible for the outgoings and often tenants don't stay long term.

When it comes to maintenance (which is almost always covered by commercial tenants), in residential portfolios the uncertainty of having to cover extra costs can become an issue, especially when you own many residential properties. We often seem to be paying thousands every month in following up maintenance problems - from a leaking tap, faulty air-conditioner or blocked toilet to more major items such as leaking roofs, asbestos problems, replacing carpets and fences, and even structural issues.

These items must be dealt with expeditiously and at your own expense. If your goal is to live off your rental income, uncertainty over maintenance costs can be a significant ongoing concern. This is not something commercial property investors need to deal with.

Lower-quality tenants are another issue that residential investors find hard to avoid. Tenants generally sign six- to 12-month leases and might stay longer, but rents are very cyclical. Compare this to commercial property, where rental increases are generally fixed at an annual 2.5% to 4%. Commercial tenants have their own brand and reputation, so naturally you will find they are more stable tenants.

Growth, too, can be more predictable for commercial property. Why? Because rental growth is a good indicator of capital growth for commercial property.

Residential is entirely market and sentiment-driven.

Don't get us wrong - we love what residential property can do for you, but there comes a point in your investing career when commercial investments need to play a part. It's simply more profitable in terms of cash flow and also more scalable, so you can build faster and more easily.

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