With strong occupancy demand from commercial tenants and investors remaining highly active in the sector, commercial real estate can be a valuable addition to your investment portfolio. Melbourne has sustained a period of high tenant demand, according to the Property Council of Australia (PCA). Forecasts indicate that by 2021, Melbourne’s central business district will supply over 480,000 sqm of new stock, with over half already pre-committed. As savvy investors look to diversify their portfolio, we reveal the benefits and risks of commercial property investment.
The Benefits of Commercial Property Investment:
1 / HIGHER RENTAL YIELD THAN RESIDENTIAL PROPERTY
The most commonly mentioned benefit of commercial property investment is rental yield. Brad Teal Real Estate Commercial Asset Manager Darren Hargreaves reports an average prime yield of between 5.5 – 6 per cent across Melbourne’s north-west, compared to 2.9 and 3.7 per cent for residential houses and units respectively (Real Estate Institute of Victoria, March 2019 Quarter).
2 / LONGER LEASES
The median duration for Victorian residential tenancies ending in 2017-18 was 554 days (approximately 18 months), according to the Residential Tenancies Bond Authority. By comparison, Mr Hargreaves estimates an average three year lease term for retail and industrial spaces in Melbourne’s north-west.
3 / OUTGOINGS CAN BE DEFERRED TO TENANTS
Outgoings includes both statutory expenses (rates, taxes, levies) and operating expenses (insurance, maintenance, building management). It’s common to pass these outgoings on to commercial tenants in the lease agreement, reducing the expense associated with holding the asset.
These expenses may be charged as gross rent, wherein outgoings are incorporated into the rent value, or net rent with a separate outgoings provision. Tenants must be given an estimate of these costs, and some may wish to negotiate their share of outgoings.
4 / ANNUAL RENT INCREASES
Most commercial property leases include annual rent increases written in at a fixed rate. This will generally be high enough to match or exceed inflation. As commercial properties are valued according to rental price, this tends to translate to increased sale prices as well.
The Risks of Commercial Property Investment:
1 / TENANTS CAN BE HARDER TO FIND
When filling residential properties, there is generally strong demand from a broader pool of tenants. People will always need a place to live and residential dwellings don’t typically have prohibitively unique features.
Conversely, depending on the property type, some commercial properties can be harder to fill. This is because businesses have more specific needs with regards to location and property type. For example, if you’re filling a retail space, this rules out prospective corporate and industrial tenants.
The transactional nature of commercial leasing, as well as extended leases and higher costs, means tenants are also more likely to expect to negotiate. In some circumstances, landlords may be expected to provide incentives such as fit-out assistance or rental free periods. Mr Hargreaves cites that incentive rates can be up to 25 per cent of the first years rent for commercial and industrial spaces.
2 / HIGHER RISK OF VACANCY DEPENDING ON ECONOMIC CYCLE
Business confidence, consumer behaviour, political climate and economic factors such as unemployment and population growth can all have varying impacts on your tenants’ business performance and long term sustainability. This influences a tenant’s decision with respect to lease renewal and extension of options, and from a macroeconomic perspective, impacts commercial property vacancy rates.
For this reason, commercial investment requires a deep understanding of economic cycles. Knowing the market is key to choosing the right time to buy, and to attracting tenants with sustainable businesses.
The Wrap: The Commercial Sector Is Solid
Whilst there are always risks with any investment category, the PCA reports Melbourne CBD is currently experiencing the lowest commercial vacancy rates on record at just 3.2 per cent, down from the previous low of 3.6 just six months prior.
Despite retail being the most challenged sector right now, demand for offices and factories remains strong. This is where Mr Hargreaves has seen investors gravitating for attractive yields and strong occupancy over the last 12 months.