Interest in buying a commercial property investment has been escalating. More investors are trying to invest in various commercial properties. Such Investors need to understand the complex commercial property market arrangements that exist.
For most investors, acquiring residential property seems easy as they are familiar with what it entails. However, the commercial property market is more challenging in comparison with the residential property market. Such a fear of unknown makes some investors to shy away from acquiring a commercial property.
To be able to eliminate the fear investors need to have adequate knowledge about the commercial property you are trying to purchase. The following is a knowledge-filled list of considerations that an investor needs to take into consideration when purchasing a commercial property investment.
Essential Factors to take into consideration when purchasing a commercial property
Factors You Should Consider When Buying a Commercial Property
Whenever you want to find out the future income that a particular investment will generate, yield becomes a vital measurement. Since capital growth rate in commercial real estate as compared to residential market is not very high, it is good to use yields to measure the real value. Thus, future returns that you will get from an investment determines whether to choose the investment or not.
Commercial property yields are calculated as percentages, based on:
- Market value/property’s cost
- Aannual income
- Running costs
Property increases over time are not considerable.
The calculated yield can either be:
- Gross yield: it is the yield that does not account for expenses.
- Net yield: It represents the yield that accounts for running expenses like maintenance costs, vacancy costs, management fees and stamp duty.
Yield as a standard measure of an investment’s income earning potential is found by dividing property annual rental income by its costs.
Gross yield = [weekly rental x 52 (annual rental income) / property value] x 100.
For instance, if a commercial property costs $540,000 and it is rent out for a weekly rent of $1120 (meaning $58,240 annually), its yield or annual growth on investment is 10.8 %. It represents the gross yield of commercial property as expenses that relate to the retail business has not been considered.
Drivers of yield
A commercial property yield’s biggest driver is property demand. Whenever the property demand rises, investment property cost of purchase also increases. The more the costs, the less the yields meaning yields are hardened. Its reversal is also true since when property demand falls, prices decline and yields escalate meaning yields are softened.
Set expected yield target
According to various experienced investors, the yield is more vital compared to an actual property price. Investors will place a target yield that they aim to achieve, check which investments meet their target and follow it closely. However, for some inexperienced investors, it’s easy to overcapitalize a property’s yield and spend more compared to what its rental income can generate.
2. Location/ demographics
Location choice of any property investment should be strategic. Variables that affect location usually change over time, some increase equity value while others decrease it. Critical variables to consider are
- The location’s visibility
- Public transport accessibility
- Potential tenants’ accessibility
- Position in the suburb
- Businesses around that support leases
- Presence or absence of similar commercial properties in the area
- Zoning and population numbers
It is important to check local council zoning laws to view what business types are permitted in a certain locality. Also, it is vital to review future council developmental plans that are likely to affect your commercial property.
Understanding demographic changes of an area is key in the selection of an investment property. For instance, anticipate the number of businesses or tenant that will be moving to that particular location. Consider whether business tenants are likely to remain the same, grow or shrink over the long-term period. Also, Check retail strips and service stations that were on a busy freeway and are now struggling.
It is beneficial to examine a commercial property’s anticipated best and highest use rather than its current use. For a borrower to gain a better understanding of the prevailing environment, it is safe to examine future, current and past demographics that encompass a commercial property before making an investing decision.
3. Interest rates
When managing inflation in the country, Australia’s Reserve Bank utilizes interest rates. As interest rates rise, money cost escalates, and companies’ growth potential is limited leading to slowed industry growth. Thus, as interest rates increase, there is a diminished consumer expenditure leading to declined commercial property demand.
Impact of interest rates to commercial property values
Fluctuation of interest rates usually affect costs of properties. As interest rates decline, it presents the incentives for investors to invest more in the commercial property market. Essentially, when commercial finance becomes more affordable, more undecided investors are likely to secure such commercial financing to acquire a commercial property.
Likewise, when interest rates escalate, no incentive will be available to influence investors to invest more in the commercial property market. Investors will be unwilling to secure commercial loans, implying that fewer investors will acquire commercial properties leading to commercial property industry stagnation.
Interest rates remains a significant factor in determining the property market. It’s crucial for investors to watch where interest rates are going.
Interest rates prediction
Strategies are available, which investors can utilize to predict interest rates trends. It’s normal for stronger economies to have higher interest rates. Thus, interests are normally lowered to raise investment level and eliminate any probable financial slowdown. It’s wise for any prospective investor that wants to find out whether interest rates are falling or rising, stay in touch with current economic trends and news.
Interest rates are not the sole determinant of cost and choice of a commercial property. Thus, it should be examined together with other factors such as population and location which also influence commercial property availability and prices. It is important for an investor to get interested rate information regarding a commercial property from a commercial property expert.
4. Lease term
Lease term of a commercial property is a crucial determinant of the kind of commercial property to invest. An investor has to ensure a property’s lease term is long enough so that finance investment can be recovered and at least the requisite profit is generated. Upon the expiry of a lease, a landlord has no obligation pressure to renew it. If that happens, your business may lose a large chunk of goodwill that has already been cultivated on the property.
Wise investors will make sure that the proposed lease provides the option to renew so that even after the initial lease term ends, activities within the premise should continue. For new investors that have no credible track record, it is better to negotiate for a short lease term initially and later, options to renew like a 1-year initial term, then 1.5 years, later 2-year term. However, well-established businesses can negotiate for longer lease terms like 2 years, 3 years, then, 5-year term.
Under the Commercial Tenancy (CT) Act, a tenant has the right to request for a tenancy period of up to 5 years, and if not able, the tenancy has the option of extending it.
Lease term details can affect whether an investor chooses a particular commercial investment or not.
Lease term considerations include:
- Usually, CPI index determines rental increases
- Lease terms can either have a 3, 5, or even 10-year term that can be accompanied with an option to renew.
- Special council approvals may be needed for certain tenancy types, for instance, medical centers, chemical treatment facilities, and childcare centers. The Department of Lands or state equivalent usually register some types of leases that are above a certain value.
- A tenant usually caters for any outgoing related to the property like corporate body fees, rates, water, amongst other expenses.
- Tenants can make necessary physical changes like installing partitions in the property.
5. Different types of commercial property
There are various property types under the commercial real estate. Commercial properties can be properties like commercial buildings, farms, medical centers, farms, factory units and retail shops. Such properties may have features multi-stream income or mixed-use dwellings.
When deciding on a commercial property type, determine the investment requirements or goals. It will enable you to have a strategic search a property type you like to invest. If it is an owner occupied property, then, property type is set. If an investor wants to offset taxable income, properties that have greatest plant and equipment depreciation should be selected.
Commercial property types
- Apartments: Considerations should be made on where such buildings are situated. Later, consider whether it’s clean, affordable, close to any facility or shop, and well maintained. Also, consider whether the apartments will provide competitive rates. In case, the location is right while the rates are uncompetitive, it is better to consider choosing another property.
- Retail: Two business types are involved in retail properties. The initial involves trying to maintain the property so that customers are attracted to it. There another one is to consider the tenant’s business profitability. As an investor, it’s good to check short term leases that raise property’s value.
- Offices: If it’s an investment that entails offices, it should be located in spaces where amenities are present like computer cabling, phone, and onsite generators. Business’s strength of the offices will dictate the property’s value.
- Industrial: For industrial buildings, the property should meet the tenant’s industrial requirements. The tenant’s business strength will dictate the property’s value.
Therefore, the kind of commercial property has a significant role to play in determining the type of commercial property that an investor should purchase.
6. Population growth
Population movement is key to an investment whose aim is growth. Usually, long-term population growth brings about long-term investment growth. Property cycles are usually independent in cities like Melbourne, Brisbane, Perth, and Sydney. However, long-term growth is usually high in populous areas like cities or satellite towns.
Many services will be demanded in areas where the growth of population is strong. For instance, when there are many new suburbs coming up, several shopping centers will be built to cater for consumer demand growth. Later on, there will be demand for grocery stores, specialty shops and cafes, then, office space and small industrial support services will emerge.
Every city or suburb has an infrastructure offering it support. Government officials plan, determine and make decisions on how infrastructure will grow in a certain area. Certain kinds of infrastructure such as rail, road, hospital projects or airport affect property values of surrounding areas positively. There are several websites in Australia that offer upcoming large scale projects information that investors can take advantage.
Commercial property demand can escalate because of infrastructure development. For instance, construction of a bypass would likely increase warehouse property demand in that region. More transport companies are likely to occupy in warehouse facilities where there is access to good roads and cheap land. When purchasing a commercial property, an investor should not be limited to current infrastructure consideration but check and investigate any future developments that may affect an investment. For instance, a proposed new freeway may increase the access to the investment premise and make a commercial property value to increase.
Funding a residential investment is not as complex as funding a commercial property. Its complexity requires that financiers who specialize in only commercial property finance. Acquiring commercial property finance is a procedure that most investors have to undertake effectively. When an investor has a poor credit score, the finance may not be approved. Before you start seeking for commercial financing, it’s advisable to seek a credit report review from a finance expert.
A business may require securing a mortgage that can be used to pay-off the cost when purchasing a commercial property. Different factors and demand will determine an investment property loan is approved. Some of the decisive financial aspects that commercial mortgage lenders look into are debt service coverage ratio, credit check, property appraisal and down payment.
Steps to gain a commercial finance
- Find a property appraiser: To determine a commercial building’s market value, an investor requires a professional property appraisal. The appraisal will reduce the risk of a lender loaning an amount more than the property worth.
- Show a good credit record: Demonstrating a good credit record is crucial in securing a commercial investment loan. Credit requirements in commercial properties are more stringent than in residential mortgage where credit score is just a bonus.
- Understand the goal of the investment: different investors’ possess different goals. There are some who will buy the property, whether an office, repair it and sell it to gain profit. While others place the commercial property in a contract before starting its development and when it is developed, it is sold at a profit. In whichever means an investor decides, down payment, financing cost, repair cost and advisor fee are crucial.
- Determine the down payment amount: In any commercial property financing, the portion of the down payment is a determinant of whether there is going to be a loan approval or not. When business property loan is big, lenders have to act with caution because it is riskier. Normally, lenders will need that a larger portion of down payment is made that is not less than 20% the property price. However, a safe down payment portion will range between 30 to 45%. Borrowers are given the remaining amount, which will be the actual loan amount. The ratio of the loaned amount to actual price in the mortgage field is known as the Loan to Value ratio (LVT). However, there exist other loans that provide 100% financing on properties.
- State the Debt service coverage ratio: the DSCR will also be a great influence to the commercial property loan. It represents the money that a commercial property generates from monthly rental income compared to the monthly loan amount. Through this ratio, lenders can determine the amount of commercial property loan that borrowers can pay each month. Most people prefer to keep that ratio between 1.1 and 1.4, where 1.4 means that the mortgaged property is generating more than the debt loan.
- Do the documentation: A borrower will need to provide financial documents like copies of last bank statements, retirement accounts (if any) and investment accounts. Social security papers, driver’s license, regular paycheck job documents and bankruptcy document may also be requested. For a self-employed borrower, occupational or business license, last 2-year tax return, business financial statement and business bank statement may be applicable.
- Assemble your professionals: Lastly, a borrower will need an experienced team of professionals. You will need a real estate attorney that deals with property contracts, and an accountant to deal with investment property tax strategies. It is also crucial to seek advice regarding investment properties from a mortgage professional. Experienced Investment advisors will assist you to identify problems that commercial property finance and offer necessary advice on how to solve it.