Commercial Real Estate Investments
There are 2 primary means for investors to gain access to real estate exposure in their portfolio. First is through the property trusts listed on ASX (or AREITs) and secondly by owning real estate directly. Commercial property is a key subset asset class within the broader real estate asset class.
AREITs can be attractive for investors that are looking for a hands off passive exposure or does not have direct property operating experience. In contrast, directly owning real estate can be attractive for those looking for a hands on approach which leverages on their commercial experience.
Why invest in Commercial Real Estate?
There are several advantages that commercial real estate can provide verses residential property investments.
The lease terms on commercial real estate assets are typical longer than residential leases. It is common to have 3, 5 or even 10 year lease term for office and warehouses. Retail leases are also typically minimum 5 years compared to 12 month lettings in residential properties.
Depending on the market, the tenant could also pay for all outgoings which covers the operating costs of the building. Example of outgoing costs include statutory rates, electricity, body corporate (strata fees), cleaning and building repair and maintenance. The landlord will be responsible for major building capital expenditures.
Also there can be more flexibility in lease negotiations between the tenant and landlord conditional on the fundamentals of the local markets. Unlike residential leases where there are legislative restraints due to difference in power between landlord and tenants. Almost all points in commercial leases are up for negotiation with the exception being retail leases where each state has its own retail leasing act dealing with the broad terms of the retail leases.
As with anything, there is no such thing as a free lunch. If the landlord or tenant require a specific clause such as right to hand back the property or demolition clauses, there will be associated costs or higher or lower rent. But it is attractive for some to have this flexibility which does not exist in residential leasing.
Investment Return Profile
The returns profile of commercial assets are also quite different. Typically these assets are more income heavy compared to residential properties where capital gains make up a large portion of the return over the long term.
It is rare to see negative gearing in commercial property since income makeup a large portion of the total return. Our analysis of long term Sydney house price gains on other hand make up the majority of returns in residential investment.
Commercial assets provides immediate income with a lower long term capital return profile. That is not to say that commercial assets are lower return asset class. The total return on investment is more dependent and leveraged to broader economic backdrop and local supply and demand than typical residential assets.
For example the Perth property market have declined on the back of the Western Australia economy is slowing down following the end of the mining boom. Commercial assets have done worse. But during the boom, the asset class outshines residential due to limited supply.
Commercial Property Loan vs Residential Property
Not all real estate is created equal and this is certainly true between financing commercial credit and residential properties. Underwriting standards and criteria for a loan against commercial properties is vastly difference to residential investment lending. The financing process can be complicated for even regular investors hence a reliance on commercial finance brokers to navigate the issue can be quite common.
It is important for those that are looking to invest in commercial real estate directly to understand the differences in borrowing costs, covenants and structure before making the plunge.
We have highlighted some key differentiating factors for those that are looking for key differences between residential and commercial property loans:
Commercial Loan Interest Rates: The rates are typically higher than cost of residential investment loans due to perceived higher risk. This is because depending on the asset, it can take longer to find a tenant for commercial properties such as retail, warehouse or office than for residential houses.
Collateral or Security Requirement: Some lenders have lower rates as they allow cross collateralize of borrowers home as well as the primary commercial asset. Hence a lower rate can be achieved by reducing the LVR by using additional collateral. Having a lease on the property is critical in securing a competitive loan rate. Costs and difficulty in finding finance increase considerably if the space is vacant.
Loan to Value Ratio Range: It is quite common to see the bank and non bank lenders to issue loans up to 90% of property value. Loans for commercial property are more conservative where the limit for the LVR usually tapers out after 70%. Also there are no mortgage lender insurance.
Payment structures: It is standard for commercial loans to be interest only. Some products can be amortizing which means a portion of the loan is repaid with every payment and there are no offset accounts.
Loan Terms: Whereby typical residential mortgages can be 25 or 30 years. The terms of commercial mortgage loans are much shorter which typically span 3 or 5 years where the bank will review and decide to renew the lending agreement or facility.
Upfront Costs: There are much more upfront cost verses residential mortgages due to involvement of various parties. This include legal fees on the loan, valuation fees for a valuation the bank would require as part of the financing process, stamp duty on the mortgage or loan as well as or larger sites a building report.
Ongoing Costs: There are potential additional ongoing costs such as line fees, account fees and draw down fees in some products. Theses fees does not have to be material however it is also something to be aware of.