Episode 008 | Commercial Property and Commercial Investment Trusts
Deep-dive into the oftentimes unfamiliar area of commercial property investment as Damian and Arin discuss the pros and cons of this property type as an investment. They look at who is suited to pursue this as an investment and how commercial property trusts can enable you to tap into the benefits of commercial property without some of the risks that come with a direct investment.
Welcome to episode 8 of our property investing masterclass
Most property investors will start their journey in residential property, hoping to build a substantial portfolio that one day supports them with enough passive income to retire. The reality, however, is that to build an income through residential property requires a huge portfolio, much larger than most people realise. In this episode, Damian and Arin discuss the merits and pitfalls of commercial property, a investment class that is often overlooked by investors yet can provide exactly what most people are hoping to achieve: high yields to build an income. Not everyone is suited to investing in commercial though, so tune in to find out if and when you should consider adding commercial property to your portfolio.
Tune in and Learn:
- Why is commercial property so often forgotten by investors?
- What are the benefits and drawback of commercial property over residential property?
- Who is suited to commercial property?
- What is a commercial property trust and what are the benefits?
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Damian Collins, Momentum Wealth: Having this investment strategy, putting a plan in place, financing your properties… In the longer term will provide higher yields than you will in the city because they carry… From an investment point of view, you’re probably not going to get the same growth as you would if you bought something older.
Property Investing Masterclass
Arin Di Camillo, Momentum Wealth: Welcome and thanks for joining us for episode number eight of the Momentum Wealth podcast series. My name’s Arin Di Camillo, manager of the Property Wealth Consultants at Momentum Wealth. With me is our Founder and Managing Director, Damien Collins. Thanks for being with us.
Damian Collins, Momentum Wealth: Great to be here again, Arin.
Arin: Good. Now we keep talking about it, the fundamentals of property investment. So, much more to it than just finding the right property.
Damian: Absolutely. It’s about… And I know we do say it each week, but just for the viewers who haven’t… perhaps have jumped to episode eight, which someone might do. Look it is. It’s about getting the right strategy in place. And I know today we’re going to talk about commercial, which is great. It’s about getting the right financing in place, it’s buying the right property, absolutely that’s crucial, but all the other things around it. And is it the right property for you and your strategy? And adding value and developing and managing those properties well. And particularly in commercial, as well as residential, property management is really an important part of that.
Arin: Sure. So, this is a 10-part series. So, if you’ve missed episodes one to seven, go to the website and check them out. There is a lot of good information there for investors, no matter which stage of the journey you are on.
So, this week, we’re talking about commercial property. We’re going to talk about different ways of investing in commercial property. But, straight off the bat, Damian, some people shy away from investing in commercial. When we think of a property investment, most people think immediately residential, but there is definitely a place for a commercial property.
Damian: Well, Arin, it’s one of those things that a lot of people think is potentially out of their price range because a lot of the buildings are like $5, 10, 15, 20, 30 million. So, a lot of people aren’t aware you can invest through syndicates and other options. But also, the media is very much focused on residential property. It’s [about] what’s happening in the housing market because, you know, people live in houses. They know it, they are familiar with it. It’s more comfortable for people to invest in, but it certainly does get a lot more media attraction as well because that’s the thing that appeals to the most people. So, people often don’t realize that they could potentially invest in commercial property. They don’t sort of seem to give it much consideration.
Arin: Sure. So, what are some of the main benefits of investing in commercial property versus residential?
Damian: Well, there are a few, Arin. And one of the main benefits is the fact that the rental returns generally are better and sometimes, substantially better. So, on a typical residential property, you will maybe get 4.5% gross yield before expenses. On commercial property, you’ll often get, you know, depending on the market cycle and everything else, you might get 6 to 7% and even sometimes 8% as well. And the other important benefit of commercial is that those yields are generally net yields.
So, you find in commercial properties that, apart from retail, which is subject to term legislation in pretty much every state in Australia, in your office or your industrial type properties the tenant pays all the outgoings. And so people don’t realize that, but if you’ve got a commercial property, an office for example, and again, it’s up to negotiation on the lease, but the standard is that the tenant will pay the rates, they’ll pay the council rates, water rates, a land tax bill, if you get one. They’ll pay for basic repairs and maintenance, cleaning, everything. So, if something breaks, you don’t have to actually [fix] it. It’s the tenant’s problem.
So, that’s really strong, whereas in residential, we’re in a 4.5% gross yield. We’ve got to pay repairs, maintenance, everything else, so it’s quite a bit more expensive for a residential property. And residential end up netting about 3% and [with] commercial you might get around 7%.
So, one of the other benefits I think, Arin, is also the length of the leases. In residential property management as, you know, anyone who has invested would know, it’s great to have a five-year tenant, but that’s not very common. Most of the time the tenants turn over 12 months, two years, three years, so you’re going to have releasing fees, all the other costs and so forth. In commercial property, often tenants will be there for, you know, 5, 10, 15 [years]. I’ve got one of my properties in Queensland, the tenant is a government tenant, and they’ve been there for 15 years. So, that’s been great. They pay on time, never have to worry about that, and been long-term tenants. So, that’s the other thing, the leases are certainly, certainly longer. And even back on the property management fees, it’s tax deductible for residential property investors – that’s great – but it’s still something we have to pay. But in commercial the tenant often pays the property management fees as well. So, again, retail is slightly different. There are some quirks in each state, but overall, yeah, there are some good upsides to commercial.
Arin: So, you’re looking at longer leases, the tenant pays the outgoings and some big yields. They’re pretty compelling benefits of investing in commercial property.
Arin: What are some of the drawbacks? What are some of the reasons we shouldn’t?
Damian: Yeah. And like anything you think, “Gee, if that’s a better yield, maybe I should go there.” And there are reasons why it does come with higher returns. Historically, commercial property has been seen as – and has performed at – lower growth rates. So, what you’ll find is that most commercial properties will generally grow in line with inflation. So, you know, you’re talking about, in the current sort of environment, maybe 3% per annum.
Now, it doesn’t always go like that. Some do outperform. Like residential you’ve got to find the outperformers. So, it’s more a yield play. But, if you’re looking for income, that’s certainly where it’s important because, let’s say, I had $2 million of net assets and you’re all in residential and you’re retired and you want to live off that income stream, in residential, you’re probably getting $50,000 to $60,000 net. In commercial, you could well be getting $150,000 net. So, at that stage of your life where growth is less important and yield becomes more important, that’s when we look to start to switch people into commercial.
So, that is a downside, that you get generally less capital growth, nothing is guaranteed. But, another one is the amount of money you would need. If you’re buying it directly on your own, the deposit is larger. So in residential, we can borrow 90% if we’ve got good credit and can service it. In commercial property, they’ll generally only lend you 65%, 70% maybe, maybe in a really good time 75%. And so, you’ve got to come out with a lot more equity. And look, commercial is definitely riskier, if you’re going it alone, and buying a property on your own. You know, [what] I mentioned earlier when I said I had a tenant there 14 years, the two years prior to that, it was sitting there vacant and it was very hard to get a tenant in. So, that was just one part of my property portfolio. So for me, it was okay. But, if it was my only investment and my tenant left and took me two years to rent out again, that could be a huge hole in my pocket.
Arin: I guess that’s the flip side of the long lease, that people tend to stay put for longer. Therefore, if it is vacant, you could be exposed for quite a while.
Damian: Yeah. Absolutely, absolutely. And it’s certain the rents are more volatile, particularly in office. When a boom is on, rents can go up substantially, but when it’s a burst and you get to sort of 20%, 30% vacancy rates, which we’re seeing around Australia, not very often, but it can happen. You can see situations where, you know, you’re vacant for years, and even when you get a tenant in, the incentives you have to offer them, you might still be getting them just paying the outgoings and not even paying the rent for another couple of years. So, it’s also the lumpier asset. They tend to be bigger, more expensive. It’s very hard to get a commercial property for less than a couple of million. That’s anything decent. So, if you’re trying to go on alone, for most people that will be a lot of their eggs in one particular basket.
Arin: You mentioned just before that investors looking for cash flow and commercial being a potentially suitable investment for them, who really is not suitable for a commercial investment property?
Damian: My philosophy has always been residential is the place to start your investing journey. It’s not where you end, okay? Because, if we’re looking at building a property portfolio, we’re looking at that to sustain us through life. And all being well, in life, if you ever, you know, you pull up stumps at 65, and you might have another 20, 30 years to go. So, that’s where it starts to come into where growth is no longer the most important thing, where it’s, “Okay, I’ve built my wealth. Now, I need to get the income stream from it.” That’s when you need to start thinking about, and not when you’re 64 1/2, you know, you’ve left your run late there. We would start transitioning people into commercial property starting in that, you know, sort of 5 to 10-year period, at least, before they’re ready to retire.
Now, I’m using 65 in the example, it could be you want to retire at 50 or whatever that number is, but that’s when you need to start looking at it. And, ultimately, a decent large property portfolio would be probably about half and half, half residential and half commercial. And you might find over time you might even sell some of that residential down potentially, but then again that will be individual circumstances. But, you get that blend of both by having a balanced portfolio. But, yes, residential start, commercial is where you want to end.
Arin: …finish at the end.
Arin: Excellent. Okay. Now, some people have said, you know, with the emergence of online shopping that the retail sector is softening. Is commercial property still a viable option in the like of all this?
Damian: Well, I guess looking forward and … So, some retail premises, I think, are going to be under threat. Certainly, anything that’s … and we’ve seen… when’s the last time … How many CD stores or record stores are around these days? Not many.
Arin: Yeah, sure.
Damian: Bookstores, not too many of them going around either. They’re all suffering because of Amazon and other online book opportunities. And so, some industries will definitely suffer, but the social aspects, the cafes, people are out, they like socializing, even though everyone sits on their iPhones and looks at things, people still like to go and talk to people, meet people. So, that is effectively retail even though it’s cafe and hospitality.
So, yeah. You’ve got to be careful, you’ve got to be thinking about the long-term, what’s going to happen, it’s the growth of the city. A lot of research still needs to go into that selection. But, we’re not going to have no retail property and we’re not going to … and for some people, shopping is an experience. To me, it’s a painful experience, but for some people, they love to go shopping. So, no matter what you have online, some people still like to go shopping. So, yeah, a lot of research. You’ve got to be thinking about the future and that’s exactly what we do when we’re looking for properties.
Arin: Yeah. Good point, Damian. Also looking at service providers, they still need a place to operate from, don’t they?
Damian: Yeah, definitely. So, the internet’s changed a lot of things, but you can’t get a haircut online. Maybe you did, Arin? I don’t know. Sorry about that one. But, look, you can’t get a haircut online, you know, those sorts of things. We’re humans at the end of the day and it doesn’t matter what you can get online. We still like that social interaction. So, yes, some things will change and go out of fashion – the CDs, the records, the books, that’s happened, but [for] other things [there] will still be a place and we’ll still need retail shops for sure.
Arin: Sure. So, if I’m in the market for a commercial property, even if I’m at that level of investor, a lot of stock is still going to be out of my reach. So, CBD stock, for example, is probably far too expensive?
Arin: Are we looking at suburban shopping centres then? Is that where we’re headed?
Damian: Well, look here. You know, some of those office buildings in the CBDs are… Well, they’re hundreds of millions in some cases. So, not too many people have got that sort of money. And even then, often, they’re in syndicates as well and so not all owned by one person anyway. So, as an individual investor and you want to buy it direct, you’re generally going to be looking at suburban locations and that may well be a suburban office or maybe suburban neighbourhood centres as well, but you’re still talking multi-millions of dollars even in that sort of space. So, you can buy some strata office stuff. Some offices’ buildings have been strata tilted, not a big fan of them. Some of those are available in the cheaper range, but it’s pretty hard to get a good commercial property sub a couple of millions of dollars.
Arin: One part of the market that’s ever increasing is medical centres, always going to be a requirement, always growing. Do they look like a, you know, a potential area to focus on?
Damian: Yes, certainly. If you look at all the job industry analysis and as part of our research, we do look where the future is going. So much growth is in the health sector, and there [are] reasons for that… that we’re getting… the Australian population is growing generally. So, there [are] more people needed for that, but also we’re an aging population. And as we age, we tend to consume more health services, but now also importantly, there [are] a lot more health service options, which is great, you know.
You [go] back 150 years ago and people didn’t live that long, but now we’re living a lot longer because we’ve got more medical things and preventative treatments and preventative scans and things. So, it’s a huge growth area, but again, there is a lot that goes into it. You just don’t … you know, it’s quite complex in the mix. You know, you’ve got your doctor practices, your pathologies, your pharmacies. There is certainly different growth here, but a lot of research and understanding of that industry needs to be done before you just go and buy something.
Arin: Sure. And I just get probably more concerned for some of us than others, Damian.
Damian: Yes, Arin. I’m a little bit older than you. Only a year, but maybe a bit more than that, but look, that’s a very specialized area, aged care.
Damian: But, yeah. That’s certainly a huge growth area as well.
Arin: So, we’ve talked about some of the benefits of commercial property. What are some of the drawbacks? What are some of the issues that we’ll face in investing in commercial property?
Damian: It’s about, you know, that risk of if you’re going direct or buying that one direct. It’s about that risk of having all your eggs in that basket. As we spoke a little bit earlier on about the loan, you’ve got a lot more equity you need, tenant vacancy… and it’s a lot of eggs in one basket. So, you know, it’s just you want to be cautious on that. And what do I say to people is if you’re going to buy one direct, you need to be able to be in a position [whereby] if that tenant goes out of business – even if you’ve got a 10-year lease, sometimes tenants go out of business – that you can sustain 12 to 18 months with no income. And if you can, then it’s certainly worth looking at buying that, but if you can’t, if you couldn’t sustain 12 months from that… with no income from that property then you probably shouldn’t be going into commercial property.
One of the other things, the lenders, they do more reviews. One thing about residential property is… and that financing there is… if you buy an investment property, it’s pretty much set and forget. You’ll never get a review from the bank. They’ll never ask you for a revaluation, particularly if you don’t cross-collateralize, they don’t ask for a re-evaluation. So, in a down market, they’re not going to ask for a re-evaluation, and set and forget. As long as you pay your interest and your repayments, you’ll probably never hear from the bank again. But, in commercial they’re a bit more … They do require re-evaluations, reassessments. They do reassess your loans more frequently. So, you just want to make sure don’t get an assessment in a down period.
Arin: Sure. Last week’s episode, we talked about developments and specifically mitigating risk in developments while going to syndicate.
Arin: Now, there is also the option to do that with commercial property by investing in a commercial property trust.
Damian: Yeah, definitely. So, in that situation, it’s similar to developments … in that it’s run usually as a unit trust and same thing. So, you might go and buy a shopping centre, for example. Let’s say it’s $15 million, a neighbourhood shopping centre, rather than you coming up with, you know, your $5, $6, $7 or $8 million deposit, you might be amongst a group of investors, you might raise, say, half of that and, you know, gear it up to 50% and, yeah. So, if you raise 7.5million, they might, you know, you might get 20 or 30 people kicking in from $50,000 to $500,000 and you’ve got that share of that commercial property. You know, if you had 7.5 million, you kicked in $750,000, you’d own 10% percent of that. So, you get 10% of the income distribution and 10% of the capital.
And so, it’s good also. Some of those funds are not just necessarily one-off properties. So, some of the funds that are out there, they’re syndicates. So, not only do you spread your risk by [not] having all your eggs in one basket, you have some of your money in that syndicate, some in another one and another one. That syndicate model itself might also be diversified and have multiple properties in it as well. So, it’s certainly the safer way to go. You’ve got a professional manager whose running it for you. They can negotiate better. They’re borrowing more money from the banks, but they can negotiate better. It’s certainly risk mitigation, but it’s certainly the asset management side becomes… you know, like a shopping centre you think, “Well, that’s, you know, easy.” But, it’s not that simple. You’ve got to think about the tenancy mix. You know, who’s in that area? And, you know, you don’t want to have two businesses that will cannibalize each other – one will go out of business. So, it’s a lot… Actually, the asset management is important, and especially if you’ve got things like shopping centres as well. So, syndicates can be, I think for most people, with commercial property, unless you’re certainly worth many multi, multi-millions of dollars, for most people going through a syndicate is going to be the way to get into commercial.
Arin: So, let’s go through some of those benefits of a commercial syndicate.
Arin: And we’re talking about lowering your capital outlay, mitigating the risk, but also diversifying your portfolio in a good commercial property trust.
Damian: Yeah, exactly. So, certainly, you know, diversification is certainly paramount because, if you had $3 million dollars, you might put half a million into six different syndicates over a period of time. So, you’ve got at least six properties and each of those funds you put in might have multiple properties within the fund. So, it’s really diversification. So, your income stream, it will be highly unlikely that all of them would have no tenants at one time.
Damian: Whereas, if you had one direct and then a tenant went out of business, then that’s obviously a big hit. So, the diversification part and risk management is really an important part of it. And you’ve got professional management, not just the property manager, but managing the assets as well within those funds. Obviously, you’re going to do your due diligence on the fund manager, but, certainly, it does provide diversification benefits. Absolutely.
Arin: So, Damian, what sort of returns can an investor expect from a commercial trust?
Damian: Arin, generally, with the commercial passive investments, you’ll be looking at like seven-ish percent. It depends on the asset. So, industrial properties might get you a little bit more. Retail funds potentially a little bit less.
The recent one that we were just speaking about was… the returns to investors is 7.5%, that’s the cash return. So, if you put in – and investors can put anywhere from $50,000 up – so if you put in $100,000, you get, you know, roughly $7,500 per annum. That’s just simply the rents that we’re getting back from the tenants in there. You also would expect capital growth. You know, that would generally be based in line with the rent growth and that will be sort of 3% to 4% per annum. No guarantees, of course, on capital growth. So, you’ll still expect to get decent returns overall, but most of it will come from the rental returns and generally less so on the capital growth.
Arin: Now, given there is such a strong cash flow asset these are suited to people nearing retirement?
Damian: Yeah. Look, we would say that certainly for people, it’s an income stream. You still might get growth, absolutely. But, you bet more of your return is going to come from income.
So, what we’re going to do is when we’re planning a person’s portfolio is to think about at what stage commercial might be suited to them. And generally, it’s in that period that you want to come towards where you want to give up your job or sell your business or whatever you’re doing. You need an income stream to live on from your properties now, whereas previously, as you’re growing and building your wealth you might have been using some of your income to help fund your properties, now it’s turning the other way around – the properties will now need to fund you, that’s when commercial starts to be… So, it’s generally for people a bit further [along] in their property investment journey, not generally when you’re starting out.
Arin: To give viewers a tangible example of what a commercial trust looks like, do you want to talk us through the most recent acquisition or most recent trust that we’re dealing with or anyone that you can think of that might be suitable?
Damian: Yes. Not too long ago, we acquired a shopping centre in Queensland. Our acquisitions teams in Commercial Funds Management Division are looking Australia-wide for investment opportunities and a very similar process with our research division providing economic outlooks for the different economies around the state, and particularly outlook for particular property sectors.
And then from there, we’ve narrowed it down to certain types of properties in certain cities. So, some cities are off the radar at the moment, some come back on. But just recently, we got an off-market opportunity, a shopping centre in suburban Brisbane, and it ticked all the right boxes, had an anchor tenant, McDonald’s, it had an IGA and another 20 tenancies in the complex as well. And so, there was a lot of research, a lot of due diligence, a lot of negotiation. The due diligence is huge when you’re buying that. You’ve got to go through all the leases and make sure you see what the terms are, the conditions, the rent reviews.
For example, the McDonald’s lease in this particular property was until 2033. So, that’s, you know, a long, long time away. And we’re subject to that lease. So, it’s a lot of due diligence you’ve got to be doing on these sorts of properties and leasing due diligence is part of it.
But, we raised the money from investors. We have our own commercial and financial services license and it was a retail fund. So, we did a product disclosure statement and investors came on board and supported the project. 7.5% returns on that particular property. And that’s going to be one that’s going to buy more retail. It’s a retail fund. It’s targeting retail properties only in that particular fund. And so, investors all start getting their returns within a couple of months, the returns will start coming back, and they’ll get their quarterly distributions. And our team will be looking after it and advising, you know, advising them on the property and how everything is going.
Arin: We’ve talked a lot about investing in commercial property either direct or through a syndicate as being a cash flow play. Does that effectively make a residential positively geared investment redundant?
Damian: Well, the residential properties that… certainly, I want all my properties to be cash flow positive because, you know, negative gearing, which we spoke about in an earlier episode, helps us afford that property, but we’re still losing money even after the tax benefits.
So, a lot of the issues with the residential ones that pay high yields is that they’re often very high risk. And we’ve seen, you know, in the mining boom, some of those mining towns, rents were $3,000 a week then they’ve come back to under $500 dollars a week. So generally, anywhere in residential, you’re getting high rental returns is generally because there are other high risks or the capital growth rate looks pretty poor. So, look, I wouldn’t say that you don’t look for a, maybe a better yielding residential property as well. That’s certainly something to consider again as part of your overall portfolio. But, if you’re looking for income stream, commercial is going to do better than a residential property.
Arin: One final question before we wrap up this week’s episode, we see a lot of older clients coming in either just before retirement or at retirement age, and they’re not quite happy with their retirement plan. Is it too late for them to invest in a commercial syndicate or is it still a good avenue for them to have a look at?
Damian: I think it’s definitely a good avenue to have a look at. And look, ideally, you would have had a property strategist working with you from much earlier on, and you would have been planning for this 10 years ago and starting to build that commercial component of your portfolio early. But, having said that, I’ve seen situations where clients have, you know, had six, seven residential properties, and that’s great, there is a lot of wealth there, but then they go, “Oh, gee. If I were to stop work, I can’t actually live on the income. It’s not good enough.” So, in some of those cases, they’ve had to sell down their residential components, some of it, and move it into commercial or higher yielding type properties, which has generally been commercial, if they want to stick with properties. So, that’s something that is certainly ideal if you’re planning for it well in advance. But, I guess worst case, you can sell down. You’re going to get some capital gains tax and feel the hits, but you can sell down and invest at that time. But, it’s something you prefer not to do. You’d prefer to start planning for that, you know, a good 10 years out at least. That’s the time that we need to be certainly hitting up and looking at that commercial space.
Arin: And look, we’ll start talking about planning and investment planning in next week’s episode. But, that’s a wrap on this week, D.C. Thanks again for your time.
Arin: We appreciate it.
Damian: No worries.
Arin: Very good work. Before we go out, as we said, bonus material is available, as always, on the website. There’ll be the usual summary of today’s discussion plus a couple of case studies on the importance of doing a thorough due diligence when looking to purchase a commercial property.
So, go to www.momentumwealth.com.au/podcast and check out all the material available for you there. Now, for the final episode in our 10-episode podcast series, we’ll be taking questions from you, the viewers. So, send any questions you might have to email@example.com and I’ll spend the final episode firing them at Damian as we go. It could be anything to do with material that we’ve covered in the series or anything outside of that as well. So, as I said, send your questions in and I’ll fire those at Damian.
We hope you’ll join us next week. We’re going to kick off by covering investment planning and the importance of putting together a strategy at the start of your investment journey. Thanks again for tuning in. I hope you join us next week and we look forward to you coming in then.