Your Guide to CommercialProperty Investment

A CONSUMER’S GUIDE

What is commercial real estate?

As the name suggests, commercial real estate is the name given to property that is specifically used in the pursuit of commercial interests. As such it is an extremely broad grouping that includes;

• Office space, including business parks

• Retail outlets, such as shops, supermarkets, and shopping centres

• Industrial property, for example warehouses and industrial estates

• Hotels, cinemas and other entertainment venues.

YOUR QUESTIONS ANSWEREDHow big is the market?

According to research from the Property Council of Australia, more than 9 million people own a combined value of $73 billion of commercial property through their superannuation, life insurance policies, listed property trusts and other collective investment vehicles.

There are more than 1.88 million small businesses in Australia employing 3.6 million people with a total capitalised value of $4.3 trillion. That is four times the market capitalisation of the Australian stock exchange, making small business the real engine room of Australia’s well-tuned economy.

What about tax considerations?

The tax deductions applicable to commercial property are very similar to those in residential property, meaning that in general the same generous benefits apply. One reason for this is that residential investment properties are essentially commercial undertakings, which is why the tax treatment and benefits applicable to both are so similar. Loan costs, the interest on loans and property management fees are all tax deductible, providing you with an excellent opportunity to increase your revenue and further reduce your personal income tax.

What about returns?

There are two core components to total returns in all investments; capital gain and income. Commercial property is no different, and it offers returns from an increase in value and from rental income.

Commercial property can often give investors higher rental yields than residential property.

Residential property typically yields income of about 4% gross a year, which means that the rent is about 4% of the purchase price. From this rental income you then need to subtract the holding costs of the property, such as rates, insurance and other fees

Commercial property investors typically earn income of about 5% to 7% net per year. This return is after the tenant has paid most of the expenses. So not only is cash flow a lot easier, the income also doesn’t have to be used to pay the outgoings that residential property investors typically have to pay.

Capital growth

Residential property is generally viewed as a growth asset whereas commercial property is considered more of an income asset. Historically, capital growth from commercial property is lower than residential. However, in recent years commercial markets across Australia have seen both strong yields and capital growth. As a rule of thumb, the higher the yield on the property, the higher the value.

This is why most commercial leases will have an annual rental escalation that improves the value of the property.

Should I buy to keep?

There is no hard and fast rule in terms of how long to keep a commercial property investment, but the recommended timeframe for holding it would be 10 years and longer. This approach helps investors avoid any downside in terms of cyclical swings in the commercial property market and to really capitalise on the long term upward pricing movements of the market.

How do you finance a commercial property investment?

The principle of funding a commercial property is very similar to that of a residential investment. Many lenders will provide the required funding for 70% to 75% of the property’s appraised value. The asset itself provides the security for the loan, and interest rates are much the same as those charged on mortgages for residential property.

LEASING

LEASED

What are some of the differences between a residential and commercial lease?

1. Length of lease

Commercial property leases are typically longer than residential leases. A 3 to 5 year lease is a typical minimum period with leases of up to 10 years not unusual. By way of comparison residential leases are often only 6 to 12 months. Commercial tenants require a longer lease period because;

• Initial fit out costs are significant and these are borne by the tenant

• Subsequent relocation costs are very expensive

• Security of tenure is required for business stability

• The premises can be a factor in the event of the sale of a business and can add value in the form of goodwill.

2. Rent reviews

Leases will include annual rent reviews normally linked to the Consumer Price Index (CPI). This has the effect of further enhancing the cash flow and capital value.

3. Owners have stronger legal protection

Commercial property leases typically include strong covenants, meaning the contractual obligations on the tenant are far more defined and far more rigorous than those in residential leases. They also provide significant legal remedies for landlords to enforce agreements on maintenance, damage or rent. Default clauses for rent arrears are also commonplace which means that penalty interest is charged for late rental payments.

4. Responsibility for maintenance

Commercial tenants have a vested interest in keeping their premises neat and well maintained because it is the platform from which they manage and operate their business. Image and presentation are crucial factors for most business owners, and their appearance is a measure of reputation and how they are judged. The end result is that tenants tend to take good care of the premises and attend to small items themselves, even capital improvements, thus saving costs for the investor in the process.

5. Responsibilities of the Body Corporate

The Body Corporate represents the interests of the owners of commercial properties when they are clustered together, for example in a business park or a suite of offices. Areas that are common to all owners include the driveways, parking bays, signage, external lighting, general interior lighting, security and gardens. These are maintained by the Body Corporate. The tenants are in turn levied for their share of these costs, enabling the investor to avoid the costs of certain outgoings and essential maintenance.

LEASED

These generally include;

• Land tax

• Body corporate fees

• Costs of lease preparation

• Council and water rates

• Building insurance.

7. Rental bond and prepayment of rent

It is usual for an incoming tenant to prepay 1 to 3 months in advance in addition to a security bond normally equivalent to 1 to 2 months’ rent.

6. Responsibility for property outgoings

While investing in commercial real estate is similar to investing in residential property, there are also many differences. Net income tends to be higher for commercial landlords, partly because the structure of leases on commercial property tends to pass full responsibility for the cost of running the property to the tenant.

Management of commercial property

As is the case with residential property, a commercial agent is best placed to manage your investment. Naturally, valuable assets require comprehensive management, and this means far more than simply collecting the rent. The cost of management is an investment in its own right given the significant value that it adds in the long run, as well as the risks that it helps to avoid. Examples include;

• Advice on acceptable lease structures so your investment retains its value and has growth built in wherever possible

• Performance of due diligence on prospective tenants

• Negotiation of lease terms with the tenant to ensure sound returns and enhanced value

• Provision of expert support to your tenant regarding queries and problems that may occur with the property and/or tenancy from time to time

• Ensuring the property is well maintained

• Advice on rental and sale values and keeping the owner informed of general market trends.

8. Rental payments

It is a standing condition of the lease that rent is paid monthly in advance.

9. “Make Good” provisions

A standard clause in most commercial leases is a “make good” provision. This stipulates that the tenant is responsible for bringing the property back to its original state, ie to re-paint, re-carpet, and to remove any fixtures or fittings that they may have installed if the landlord so requires.

Purchase price

Commercial property may be subject to GST on the sale price. For example, if both seller and purchaser are registered for GST but there is no lease, the purchaser will pay GST and claim it back in the next BAS return. Alternatively, no GST is added to the purchase price if;

• Both seller and purchaser are registered for GST

• The lease satisfies the “Going Concern” test*

• The sale agreement states that it is a going concern.

*The “Going Concern” test is basically a test as to whether the purchaser can step into the seller’s shoes with minimal impact upon the tenant. The seller must supply all of the things necessary for the continued operation of the entity and carry on the enterprise until the day of supply.

GST AND COmmERCIAL PROPERTYOngoing tax considerations

In most cases it is appropriate for the purchaser to register for GST in order to claim back the GST charged on costs and avoid being disadvantaged. It is important that the vehicle used to purchase the property is the one that is registered, whether this be personally or in a trust or company.

The owner charges GST on the rent and recovers GST on all costs. The submission of a quarterly BAS statement will cover this requirement. Accurate accounting records need to be maintained.

Note: The above is a brief overview of the GST ramifications. A prospective purchaser of commercial property should seek independent advice before proceeding.

Commercial property risks

Investments that offer higher returns carry correspondingly higher risks. Commercial property is considered to be riskier than residential property, although this topic is hotly debated within the industry.

Examples include cyclical economic trends, shifts in industry or sector competitiveness, or downturns in the economy that lead to economic hardship. Put differently, when business tenants feel the economic pinch, so do their landlords.

Location

While it may seem obvious, commercial properties in close proximity to major cities generate the highest returns on investment. The location and demographics of the area are critically important, as is accessibility. A property located with good access to transport nodes such as motorways, rail freight routes, airports or commercial shipping harbours will generally be in strong demand.

OThER FACTORS TO CONSIDER

The value of a location can vary over time. Improved transport links can boost the value of property by making it more accessible to potential tenants and users. Other fundamentals such as building age, condition and level of specifications are all also key factors in the demand for a property, the rental that it can command, and the speed with which it can be re-let.

The right building

The building should be attractive, modern and well designed and of a size that suits the area’s potential. It needs to be of sound construction with maintenance needs kept as low as possible. As a rule modern buildings usually need less upkeep than older ones and are also more attractive to tenants. Key ingredients include;

• Air-conditioned office space

• Accessible delivery areas

• Ample parking for customers and staff

• Natural light

• Adequate ceiling height

• Sufficient power and data points

• Internal toilet facilities

• Internal kitchen facilities

• Minimum column grid.

Selling your commercial property

As with a residential property, a commercial property can be sold at any time by a commercial agent, with any existing leases transferred to the new purchaser.

Title to the property

Most property investors would be familiar with a strata-titled apartment building. Commercial properties would generally fall under this category.

Capital Gains Tax

The capital gain on the sale of any property, whether commercial or residential, is treated by the ATO in the same fashion. Capital Gains Tax (CGT) is payable upon the realized capital gains.

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This guide is intended to provide general information of an educational nature only. Any information contained in this guide does not have regard to the investment objectives, financial situation or individual needs of the reader. Neither McCarthy Group Pty Ltd nor its affiliates intend by this guide to provide any financial product advice, and information in the guide cannot be relied upon as such. All readers should consider obtaining independent advice before making any financial decision concerning property or any other investment product. D

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