Diversification: The Key To Success
When it comes to commercial investment, it’s best to not have all your eggs in one basket, writes Ulf Führer.
1 January 2022
If you’re like most investors, this time of the year you will be trying to relax in a sun lounger while attempting to avoid hyperventilating about the year that was and the year that is. It’s also a time to re-evaluate investments, investment strategies and assess whether it’s all worth it. So, take a deep breath, and keep reading; there is more good news than bad.
A host of legislative changes in the residential investment market, together with what history may record as a residential market peak, would leave one forgiven for doing the unthinkable and selling all residential properties you may own and investing in a stable and fastmoving commercial market.
Go to any economic seminar or read any article and you’ll always hear economists espousing the virtues of diversifying portfolios to mitigate risk.
Despite this advice, however, many property investors lack proper diversification in their portfolios, tending to find one or two property types that work for them and then stop.
A balanced portfolio should always contain different asset types to limit and spread the risk across different sectors, industries, regions and sizes, weighed up with the expected length of time one is going to hold onto the asset.
An obvious advantage of a welldiversified portfolio is that if a specific investment does not do well, other investments in the portfolio that are performing better can dampen the overall risk.
If property is your thing, however, one of the most powerful strategies you can use to maximise the long-term growth of your portfolio is diversification between residential and commercial. By investing in a variety of real estate assets, you can lower your overall risk and increase your chances of higher long-term returns.
It also means you can take advantage of one type of property asset if another one isn’t viable. For example, there is no bright-line test for commercial property, so you can buy and sell as many properties as you want without being caught in the bright-line net. Also, many of the investment benefits that have been closed for residential investors are still available to commercial investors.
So, where do you start when looking for a commercial investment, and what should you be looking for? Below are the different types of property you can invest in under the broad term of “Commercial Property”, with key things to keep in mind when investing in them.
Retail—high-risk but high return. Square metre rates in good locations will continue to be high, but second grade stock in less desirable locations may be harder to tenant. One would have to question how long it’s going to take retail to bounce back after the recent lockdowns and what the appetite is for new businesses to enter a struggling market.
Hospitality —high-risk but can have high returns. In the current Covid environment it is one that many would be wary of investing in unless you are looking to reconfigure a property for a specific secure tenant.
Office—medium risk with medium returns. Good tenants are government or pseudo-government agencies, but buildings need to be more than 67% NBS. Otherwise, no government tenant will touch it. Also, banks don’t like lending on a property that is below 67% NBS, so depending on your financial position, bank funding may be hard to secure.
Commercial—medium risk and tenants are usually seen to be reliable. Returns are good, and the asset is worth holding long term. When a town or city expands, this type of stock often gets rezoned to residential or mixed-use.
Industrial—lowest of the returns and equally the lowest risk. Most of the time the asset just consists of a large shed, and very little can go wrong.
NOTE: Depending on the size of the tenant and the length of the initial lease, teamed with how well the lease has been prepared by the agent you are using, it will affect the long-term value of your investment.
Buy Stock Nobody Else Wants
Generally, this would be vacant stock, as most investors want to buy something easy with a solid WALT (weighted average lease term) and a good yield (return on investment), maybe at say 6%. You will be able to buy vacant property cheaper than tenanted property, and vendors are likely to be more open to a heavily structured offer (weighted in the purchaser’s favour) where you could possibly have it leased before you even settle.
Be smart and remember that smaller tenancies pay a higher rate per square metre. Think about what you are buying and how you might be able to split it into multiple tenancies. This transforms what would be a capitalised yield at 6% with one tenant into a 10% yield, spreading your risk within the same asset.
Depending on what it is, you may even be able to split it across different industry sectors, for example, as office on the top level, retail on the street, and light industrial to the rear. This is often called a “full house”, and you can then either hold it long term and make a solid 10% yield or sell it to a lazy investor at 6% and walk away with 4%+ on your initial investment.
Do's And Don'ts
• Any property in the commercial space that is below 67% NBS limits your tenant and bank lending options.
• Hospitality is a high risk unless you have a tenant lined up before you settle and look at it as a short to medium term investment.
• Don’t rely on what you are being told about a property and do your own investigation.
• Decide from the start if the property you are looking to buy will be a medium or long—term hold or a flip. Obviously, everything is for sale at the right price, so this might change.
• Read through any existing leases and make sure you understand them, as they can contain things that might hinder or completely stop the plans you have for the property.
• District plans change. As dull and vague as they are to read, spend some time understanding the council’s intentions for the future as this can dramatically increase or decrease the value of your property. One day you may have bought a property on a main street; next, a bypass goes in, and you are on a back street.
• Most commercial agents can list and sell anywhere in the country, so don’t feel like you need to use an agent in the area you are looking at buying. Find an agent you trust and use them. Some agents work under buyers’ agencies, where they work for the buyer and find them properties around the country. An advantage of this is that the buyer is not in competition with other buyers, and under a buyers’ agency, their job is to drive the price down rather than driving it up when working for the vendor.
As always, remember—sell high, buy low.