How to invest in Commercial Property: Part 2

how to invest in commercial property

This is the second part of a two-part blog about investing in commercial property (you can read part one here). Now that you have a broad understanding of commercial property attributes, the next topic to discuss is how you can successfully invest in commercial property. 

Why type of commercial property do I recommend?

Personally, at the moment I invest in commercial offices, and recommend the same to my advisory clients.

Not retail property

I do not invest in retail property because the profit margins in the retail sector have been under increasing pressure and landlords are not immune to the impact of these pressures. Rental yields are already relatively low in the retail sector, and they could be compressed further, which will adversely affect asset values. Overall, I don’t find this sector attractive.

Not industrial property

Whilst the high rental yields that industrial property offers is certainly very attractive, there are two downsides. Firstly, industrial properties tend to have a single tenant (i.e. no tenant diversification) which could lead to protected periods of vacancy (3-6 months is not uncommon). Secondly, these assets tend to provide very little (no) scope for improvement.

I prefer offices for these reasons

I am more attracted to office buildings because it offers tenant diversification i.e. an office building might have 20-40 tenants, so the likelihood of a materially lower income due to vacancy is lower. In addition, office buildings can provide scope to add value to the asset. There are two primary ways to do this.

Firstly, you can ensure the building offers the same amenities that newly built towers do. That can include a refurbished foyer/atrium (so its attractive for staff and clients to visit), end-of-trip facilities (such as showers, bike racks and so on), offices that are already fit out and ready to be occupied, etc. These capital improvements are all aimed at achieving a higher rent per sqm.

Secondly, you can improve the landlord’s relationship with the tenants. Ensuring tenants are well looked after and satisfied with the building is critical in reducing tenant turnover/vacancy and maximising rent. Weighted Average Lease Expiry (WALE) is a key metric that is used with office buildings to measure the strength of the property’s income stream. Increasing the WALE, reduces the capitalisation rate, which increases a buildings value.

Investment option: Direct ownership  

One option is to purchase a commercial property to own directly i.e. you own 100% of the building, just like you would do with residential property. Of course, one downside with this option is that if you have a limited budget, you may need to compromise on the quality which is never a good idea.

Whilst it is highly dependent on the type and location of the property, I suggest that you need a budget of at least $2 million to invest in a satisfactory commercial property.

One of the advantages of having a direct investment is that you have absolute control over the asset. You can decide who will occupy it and what you do with the property in the future, especially if it has an alternative use.

If the property only has one tenant, which is likely unless you have a large budget, then the risk that a vacancy adversely affects your investment income is also high. It is not uncommon for vacancy periods to be 3 to 6 months, even longer if you have to offer the tenant an incentive (e.g. rent-free period).

My wife and I have invested in direct commercial property and enjoyed excellent returns (sold in 2020 because we received a stupid offer). It is our view that these assets are currently being sold for unreasonably high values. Commercial property tends to be cyclical, so if it presents value in the future (maybe when interest rates are higher), we will reconsider it.

Investment option: Shared ownership

It is possible to co-invest in commercial property with other investors (often called investor syndicates). This typically comprises of a group of investors that purchase a building often using some debt (e.g. borrowing 45-50% of the purchase price). Often the asset is owned in a unit trust and each investor owns units in the trust (fixed entitlement).

There are several commercial property businesses that arrange property syndicates. Like with anything in the financial services sector, you must be extremely careful with who you deal with. This is particularly the case with commercial property syndicates, as I think most of them make very poor investments. You want a team that has extensive experience (runs on the board), skin in the game and most of all, high integrity and morals.

Syndication offers many advantages. The main one is that you can level up on quality because you have a higher budget. There are lots of buyers in the sub-$10 million market (super fund and wealthy individuals), so the deals tend to be less attractive. However, offices that sell for say $20 to $80 million tend to be too expensive for individuals, but too small for institutions, so there is less buyer demand and therefore more attractive opportunities.

The other advantages are that the risk of suffering a reduced income due to vacancy is lower because a large building will have many tenants. If you have a large sum to invest, you can spread that across several buildings, to increase your diversification. Finally, the investment manager will manage the whole process to maximise your returns e.g. asset sections, acquisition, capital improvements, property management and so on – it is truly a hands-off, passive investment.

The main disadvantage of this investment is that the units you own in the unit trust can be illiquid. That is, if the investment turns bad, you will probably struggle to find someone willing to buy these units from you. This is true for most investments (it’s always hard to sell a dud investment). The best way to mitigate this risk is by having the right investment manager and ensuring the property is a good asset.

Some might consider lack of control (compared to direct ownership) as a disadvantage, but I don’t. I’m not a commercial property expert – it’s not my day job. I think it’s wise to leave investment management to the experts. I like it that an expert that I know, and trust is looking after my best interest.

Investment option: Real Estate Investment Trust (REIT)

The final option is to invest in a Real Estate Investment Trust (REIT) which can be offered in the traditional management fund form or ETF. REIT’s are pooled investment vehicles that invest in in Australian or global property, simar to managed share funds.

According to data compiled by S&P Dow Jones, between 60% and 80% of actively managed REIT’s fail to bench the index. Therefore, I adopt the same approach with REIT as I do to manage shares. That is, I use low-cost, passive index’s, not actively managed funds to invest in this sector (such as this Vanguard fund, for example).

I tend to avoid Australian REIT’s because they have too much exposure to retail property e.g. shopping centres.

Whilst this option definitely has merit, I consider shared and direct ownership to be superior because you have more control over the quality of the underlying asset that you are investing in and therefore can select something that is well-priced and offers scope for improvement.

Commercial property must be a part of a larger plan

Deciding to invest in commercial property without a long-term financial plan is like asking for directions without disclosing your designation. A long-term plan provides necessary context. It helps answer the question; should I invest in commercial property? If so, when and how much.

Commercial property is a wonderful investment which I invest in personally (only hold syndicated investments now) and recommend many of my clients do the same. It compliments other investment classes and I encourage you to consider it.