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Commercial property investing

Commercial property investing

Investing in residential and commercial real estate has long been a popular avenue for wealth creation, but there are big differences, as Sally Lindsay discovers.

By: Sally Lindsay

29 May 2024

There is a deep-rooted belief in the long-term rewards that property offers.

Although enduring confidence is held in residential investment, the same sentiment does not extend to commercial property. Investors with residential property investments outnumber those with commercial investments by five-to-one, even though both are a store of wealth.

Like most investment decisions, investing in either is not “absolutely” or “never”. There are some differences that need a level of understanding before final decisions are made.

Both offer enticing investment opportunities, but over the past few years some residential investors, taking exception to the previous Labour government’s tax changes and the legislative war on landlords, have ditched residential in favour of commercial.

Former New Zealand Property Investors’ Federation chief executive and Hawke’s Bay Property Association spokeswoman, Sharon Cullwick, says many members were looking at switching to commercial property after the tax announcements, but lending changes under the Credit Contracts and Consumer Finance Act made it too difficult.

Demand, particularly for industrial property, has surged in the past few years and the entire commercial property market is expected to reach $363.4 billion this year and grow at 3.07 per cent a year to $415.5 billion by 2028.

Recent analysis shows the average return on investment for commercial properties – excluding rates, property management fees, and other costs – is between 5 and 5.5 per cent, while for residential properties it is 3 per cent on average. These returns can vary depending on various factors such as the area, the state of the economy and any external unprecedented forces, like a pandemic.

The fundamentals for successful commercial investment boil down to location, nature of the property (office/industrial) supply/demand within those sectors, construction, including earthquake strength, current rentals to market, alternate uses of the property and is the property fit for purpose (i.e. an older industrial property may not have the floor loading and stud height to deal with existing requirements).

Savills head of industrial sales and leasing, Paddy Callesen, says owning and/or leasing commercial and industrial property has grown to become a sophisticated market for those viewing it as a long-term asset that can provide above normal returns. 

Industrial properties are on a net yield, tenants pay most of the outgoings, and there is no or little government interference.

Higher Yields

Residential property across the country is valued at $1.62 trillion and is by far the biggest investment property category. More than 80 per cent of residential investors own their own home and have one investment property.

While residential properties offer stable demand and easier entry, they come with higher rates of tenant turnover and regulatory hurdles. On the other hand, commercial properties offer higher rental yields and longer leases but require more substantial upfront investment and are sensitive to economic conditions.

Banks will typically want a 40-50 per cent deposit on commercial property, interest rates of 9 per cent-plus if the loan is secured against the premises, to be paid back over 10 to 15 years, and strong leases with the amount of income they generate and the term remaining on them – a weighted average lease term.

Over the past couple of years when residential investment dried up under the previous government, iFindProperty added commercial to its arsenal. But while it has been a slow burn it has been worth the effort, says operations manager and co-founder, Nick Gentle.

The agency has attracted buyers with several million dollars and, interestingly, none of it made from the property market. It’s mainly been from business ventures.

iFindProperty has done five substantial commercial deals and only targets industrial property, which has been the darling of the sector for the past few years. In the past two years the best rent growth has come from industrial and the top end of the office market, he says.

A CBRE report at the end of last year showed vacancy rates in the industrial sector remained below 1 per cent and prime industrial, large format retail and premium grade office properties are expected to lead rent growth over the next five years.

Gentle says because industrial properties are on a net yield, tenants pay most of the outgoings, and there is no or little government interference, investment starts to appeal.

iFind’s first commercial client had a budget of $4 million and completed three deals. The second client did a deal significantly under budget, but it has valued up substantially and he is now positioned to buy another property.

Typically, clients are not really thinking about a number of properties, Gentle says. “It’s more like commercial real estate, please, and then it’s whatever is the best combination of deals.”

However, his team has steered away from dealing in properties under $1 million. Many of these are blocks of small industrial units that sprang up over industrial areas from the mid-2010s, suited to tradies, wealthy people wanting to park their boat, or storage.

Many have not performed that well, Gentle says. “The smaller and cheaper industrial properties are, the more buying competition there is and the tenancy profile changes. A tradie will not want to sign up for a five to 15-year lease, such as a major corporate or big retailer will do.”

Changing Property Market

iFindProperty was approached by a developer three years ago to potentially market a block of small units, but Gentle says it was too difficult to make the figures work.

One aspect of the market that has recently struck him and his Wellington agent, Peter Ambrose, who has done all the commercial deals, is the number of commercial properties being sold with vacant possession.

“It seems the number is increasing, so either tenants are ending their leases and not renewing, or businesses are simply shutting down.

“Investors might be able to get a bargain if they can sign up a new tenant to go in as soon as they have bought the property, particularly if the tenant signs up for a five year-plus lease.”

His agency sold an industrial property in Auckland recently with two tenancies – one leased and the other vacant. The client was happy with the risk because he had a tenant he was confident would stay and the other he could lease. “He felt the risk was worth it as the value of the building is often tied to the lease as much as the bricks and mortar.”

Savills’ Callesen sees residential investing as only for capital growth and the switch to commercial is a substantial jump. For investors with a house sale and about $450,000 to $1 million cash, the traditional route has been investing in syndicates, listed and unlisted property funds. Not many can afford to buy a commercial/industrial property outright.

While syndicates have had a chequered history, Callesen says four out of five times the property market is either OK or good.

“This is one of the 20 per cent of times there is a bad market and some syndicates or unlisted funds have stopped distributions as high interest rates, lower property valuations and costs have caught up with them. It’s difficult for investors because the syndicates and funds are mainly illiquid and that is the risk when investing.”

He says if investors spread their risk over multiple tenants and multiple buildings in a conservative syndicate with no debt they would be doing reasonably well, and it is still a good way of staying in the property market when they get sick of dealing with unruly residential tenants and property maintenance.

If an investor has made their money in residential and is now an investor in commercial/industrial property their capital is reasonably safe because the building is standing, and it has tenants.

“If over the next one to two years the income from the investment dries up it doesn’t mean the asset’s value has dropped or even come back to what was paid for it. There is still capital growth even though the income might have dried up temporarily.”

Syndicated funds serve a good purpose, but can experience ups and downs, like all property.

Property syndicates

Callesen says syndicated and unlisted funds serve a good purpose, but there will always be times they are not performing and investors just have to “guts” it out until the tenancy is renewed, rents have been reviewed and the market’s a bit better – everything is in alignment – so they can sell their units or shares or go to the syndicator and say, as a collective, we think now is the right time to sell the property. “It’s all about risk and reward.”

Some syndicates have ridden the hard times and are now listed property funds, with investors becoming shareholders who now have liquidity by being able to sell their shares.

Now the government has said investors can start claiming mortgage interest as a tax deductible expense again and the brightline test will be pulled back to two years, Gentle believes residential investment will take off again this year, although there have been few signs of that so far.

He says his phone started ringing in mid-January and hasn’t stopped. His company has had more inquiry in the past two months than it had all of last year.

Commercial buildings can run the spectrum from agricultural and warehousing, to manufactuing, workshop and maintenance. Images: XL Structural

Commercial Property pros and cons

Timaru-based XL Structural, which specialises in designing and building, has laid out the pros and cons of investing in commercial property, saying any potential investor needs a clear understanding of their individual financial goals.

Pros Of Commercial

Higher rental yields: Commercial real estate has historically offered higher rental yields than residential real estate. This makes commercial properties attractive to investors seeking regular income streams.

Longer leases: Commercial leases tend to have longer terms compared with residential leases. This provides a more predictable rental income with fewer vacancy periods. 

Professional tenants: Commercial properties tend to attract professional tenants, such as businesses and corporations. This typically leads to lower maintenance costs, better property care, and a less emotional tenant-landlord relationship. This can make overall property management much easier. 

Diversification: Investing in commercial properties can offer more diversification and less risk. This is because their performance is less correlated with the residential market.

Cons Of Commercial

Higher entry barriers: Commercial property investments typically require higher upfront capital. They may also involve complex financial structures, making them less accessible to individual investors. This may mean you are much more dependent on one asset, rather than multiple residential properties. 

Market Sensitivity: Commercial property values and demand can be more sensitive to economic fluctuations and business cycles. In economic downturns, this could increase risks.

Property Management Complexity: Commercial properties may require specialised property management expertise due to the unique needs and demands of commercial tenants.

Vacancy Risks: Finding new tenants for commercial properties can take longer compared to residential properties, leading to potential periods of vacancy.

Leverage: Typically, banks will not lend as much for commercial as they will for residential. For an investment, the bank will generally fund less of the purchase price of commercial real estate, generally a maximum 50 per cent (although there are always exceptions), and then additional conditions on the funding from loan-to-value ratios (LVRs), interest cover ratios and any other conditions they deem appropriate for the transaction.

Commercial Building Valuations

Assessing the current value or recent sales values of commercial buildings can be difficult as the RV of a property can be quite different to its value if it was sold today.

XL Structural says the dominating factor in the commercial market is the rate of return, commonly known as the capitalisation or CAP rate. This is the total value of the rent as a per cent of the value of the property.

For example, if you have a $1 million property and the rent is $60,000 per annum this is a 6 per cent CAP rate. This can be reversed to calculate the value of a property.

For example

If the rent of a warehouse is set at $100,000 per annum and an investor is looking for a 6% per cent CAP rate, it means they would be willing to pay:

$100,000/6 per cent = $1,666,667

This means if you know the rental value and the CAP rate you can calculate what property might be worth.

Ratings for things like exterior hardstands and offices would need to be taken into account, along with local rates.