Is a small commercial property an option for the average investor?

Australia’s obsession with property investment is largely focused on direct investment into residential housing.

Buying a house or unit, using negative gearing to offset cash flow losses against other income sources (usually a salary), has become a national pastime for many. But the idea of investing in a small commercial property isn’t something many people seem to think possible.

There are reasons why direct commercial property has advantages over residential housing. Yields for example – the income return as a percentage of acquisition costs – are often higher.  Commercial or industrial property can return from 5 to 10 per cent on initial yields. Residential by comparison might only yield 3 to 4 per cent.

Investors have tended to accept low yields on residential property because of hoped-for future capital gains. But with house prices pushing global limits relative to incomes, is the prospect of future capital gains something to be questioned?

Also consider that tenants of commercial properties typically pay all outgoings in addition to the rent and utilities.

This means the landlord can recover the costs of management, repairs and maintenance from the tenant. Even council rates and state taxes can be recoverable. With residential property, these costs are usually borne by the owner.

Another consideration is the nature of lease and the laws that govern it. Residential tenancies are highly regulated by government legislation, to the extent that many investors complain they are unfairly biased in favour of the tenant and a disincentive.

Removing non-paying or destructive tenants can be problematic in some jurisdictions and leave owners with large, unexpected costs. Commercial leases are generally more ‘commercial’ – in that the rights and responsibilities under the lease are typically more balanced.

Retail shop leases can be an exception in some jurisdictions, with laws enacted to protect smaller retail businesses from unscrupulous landlords. But this is more likely to be contentious in major retail centres, and less likely in standalone retail premises.

Commercial leases are also usually for much longer terms. A residential lease is typically for a year or less (with ability to renew by negotiation). According to the Residential Tenancies Authority (Qld) the median lease term across all rental agreements is just 17 months. Commercial leases however can be for five years or more, with options to renew (for maybe another two or five years) built into the contract.

This gives the investor a much longer and more predictable rate of return on their commercial property investment.

A better class of tenant

Rent reviews can be built into commercial lease agreements in a more favourable and predictable manner than for residential property.

Many commercial leases include fixed review terms, or minimum CPI increases, or increases to market, or a combination of review methods. This can be every year or two.

It tends to mean the commercial lease will continue to reflect market conditions and not be eroded over time by inflation or limited opportunities to review to market, as with residential.

Then there are the tenants themselves.

Investors in residential property may have several tenants over the life of their investment, whereas commercial tenants tend to stay longer as they become more invested in that location.

Some will outgrow their location, and some will go broke, but if you choose a property based on the quality of the tenant and the property is well located and suited to their needs, it is possible to have a tenant that will stay in that property for many years.

Diversified property income sources

Commercial property can also be more flexible in the type of tenants it attracts.

Depending on local zoning laws, for example, what was once a suburban corner store could be converted into offices for local real estate agents, lawyers or accountants – with little modification.

That use could change again into medical rooms for GPs, or for allied health professionals – one of the fastest growing sectors of the economy.

This long-term flexibility of uses by occupiers, especially if the property is well located, gives investors more options over the life of the investment and the ability to chase the highest returns depending on the economic cycle and the opportunities it presents at any stage.

Depending on the size of the property in question, it may house more than one tenant.

This can prove another added benefit of commercial property in that your income sources are diversified. If one tenant should fail, for any reason, you have others paying rent while you find a replacement.

The commercial property market is also projected to be heading towards a strong 2025.

Higher returns, more favourable and longer-term leases, and potentially more flexible uses over the life of the investment – just some of the reasons that even ‘mum and dad’ investors might look into commercial investment and how it compares with residential.