Across Australia and New Zealand, investors seeking stable, long term returns in volatile markets, are considering commercial real estate. Once reserved for speculators, developers and ultra-rich, commercial property investment is becoming an increasingly mainstream choice.
At first glance, the attractions of commercial over residential property are obvious, Landlords of commercial property achieve higher yields, longer leases and have more power when it comes to dealing with troublesome tenants. But, as in all asset classes, the benefits are offset by risks. In this case, unpredictable capital growth, higher vacancy rates and complicated leasing agreements.
Investors who prefer the security of blue-chip tenants such as banks, petrol stations and fast-food chains may also find themselves in fierce negotiations with professionals trained to squeeze every last dollar from the deal. As with any form of investment, it’s crucial to approach the commercial property market with your eyes wide open. There are potential pitfalls that cannot be ignored.
The structure of leases is a key advantage of commercial property investing over residential. While residential leases usually run for six to 12 months, leases on commercial property run for three to five years, or longer, with built-in options for the tenant to renew. Commercial tenants spend considerable sums fitting out the premises and they’re typically keen to stay put once they’ve set up in a particular location. Fixed rent increases are incorporated into most commercial leases, so the tenant’s rent rises by the inflation rate, an agreed percentage, or a mixture of CPI plus a set percentage each year. These terms are agreed at the start of the lease.
Generally, commercial leases are underwritten by a personal director’s guarantee or a bank guarantee. If the tenant defaults on rent, the landlord has the guarantee to call upon. With a residential property, the only guarantee the landlord has is the bond, which may be eaten up in cleaning or repairing the property after the tenant has vacated. Commercial leases usually include a “make-good” clause. If the tenant does not extend the lease at the end of its term, they are obliged to reinstate the property to the state it was in on the day they took occupation. That’s important for commercial properties as it might involve recarpeting, repainting or removing the fit-out. Unlike residential leases, commercial leases are typically paid net of expenses. That means the tenant pays outgoing costs such as council rates, land tax, utility bills, insurance, repairs and maintenance, security, gardening, and sometimes property management fees too.
Gross rent is quoted before those outgoings, but the net rent is what the landlord receives and what is used to calculate the property’s yield. If the lease is quoted as $200,000 a year gross, and outgoings cost $50,000 a year, most commercial property agents will advertise the net rent as being $150,000. If council rates suddenly jump or insurance rates go through the roof because a storm has gone through the area, or land tax is reassessed and doubles in value, [landlords] don’t have to wear the cost. The tenant wears the cost. In residential investments, rents are charged on a gross basis, so the landlord is responsible for covering costs such as strata fees, water bills, insurance and council rates from the income, and that erodes the yield.
Deciding which costs are included in a commercial lease is an important part of the initial negotiations between the tenant and landlord. Many landlords appoint a professional manager to negotiate the lease on their behalf and have a specialist lawyer look over the documentation.
Major tenants will have dedicated teams that handle negotiations from their side and have experience getting the best deal for the tenant, so it’s wise to get individual advice on establishing a lease. Commercial property landlords whose leases do not include management fees can expect to pay about 2 per cent to 5 per cent of the rental income as a fee, depending on the property’s size and the number and quality of tenants.
(Smart Investor Magazine, Commercial or Residential, August 2013, p32 and 33)