Thoughts on investing in commercial vs buying residential

I'm thinking of purchasing my first residential property (PPOR) and turning that into an IP.

However, when you run through the numbers from a cash flow perspective, the numbers really don't stack up. You will need at least 10 years of rent growth for the rent to cover your mortgage and this isn't including all your outgoings like PM, maintenance, etc. All you're counting on is capital growth and leveraging that out into other IPs.

Commercial properties will be cash flow positive from day one and all outgoings are covered by the tenant.

It makes more sense to rent and buy a commercial property vs buying a home.

What are your thoughts on this? Is this a viable strategy?

 

You're just looking at it from a cashflow angle though. You're missing the part where a significant amount of the money you make is from the capital growth and leveraging opportunities.
Which frankly, generally would dwarf any cashflow losses or gains if you're doing things right.

Otherwise we'd all be buying properties in Broken Hill.

 

Commercial properties have capital growth too and that would be based on the income that property is generating. Higher income = Higher valuation. Plus, the valuation increase is less risky because most leases increase 3-4% (and that is almost guaranteed if it's in the contract) YOY which would result in a higher valuation.

What would you leverage your equity into?

 

Yeah I completely disagree with this. That is a very, very simplistic analysis and I hope you don't base your long term strategies on it.

 

To me, something that is in a contract where the tenant has to pay a 3-4% increase in their lease is less risky than counting on capital growth based on what the neighbors are selling their houses for in this low interest rate environment.

By the way, how's your experience in investing in commercial properties vs residential?

Thanks for sharing, geoffw.

Would you be able to look into the financial statement of the tenant before leasing it to them? For example, a business that is making a loss would be a terrible tenant.

Any key takeaways from this experience?

 

I have seen some horror purchases where investors have purchased purely on the yield. Look at the quality of the tenant, the postcode/area, any new developments proposed in the area that may affect your property.

Commercial properties can be excellent but you really need to do your homework and know what you are doing.

 

As a rule of thumb these more passive types of CIP are expensive. For the price of a PPOR/IP you are looking at a much smaller CIP which will be at risk of having Lessees get into arrears, go bust and/or both.
CIP sounds easy as the Lessee pays a lot but it's generally only good when it's tenanted and the tenant is paying. When it's vacant or tenanted and the tenant is not paying it is very very very vacant and can take months to get another tenant in and they may want fitout contributions etc.
And yes I have CIP and RIPs. I actually prefer RIPs.

 

Where abouts did you read these lies!!!

More lies.

To actually add something of value to my response....Commercial is no more complicated the residential, if anything it may be a little easier. Investing in resi is complicated when you don't know anything about it but you research, learn and ask plenty of questions and it start to all fall into place....same with commercial.

Knowing the market yield (or cap rate) you should be applying to the net income to value a property at takes time and experience. Retail/Industrial/Office/torrens title/strata title/lease terms/development potential plus other macro factors like interest rates all play their part in determining how to value a property. It's not one of the 'dark arts' it just takes experience just like valuing residential property.

If you believe all tenants pay outgoings you haven't look at many commercial properties. Get out and look at lots more.

 

You're speaking in absolute terms. Nothing is absolute in property let alone commercial. Commercial is a beast with very big horns - if you don't have the resources to tame the beast (knowledge and funds) stay away until you have done a lot of homework and have a some experience and a solid financial foundation.

 

My experience in commercial is purely retail, and if you have selected the correct property, the capital growth + rental increase is way higher than residential, not to mention you dont have to do anything as all reno are done by you tenant not the owner. Yes, the value of the shop is base on the rental income, but make sure you are selecting a shop that there are having a lot of pedestrian traffic, else the rental income may be high, but the once the tenant left, the vacancy period can be long, i.e. > 6 months.

For tenant, you can just make sure they pay at least 3 months bond, and also buy insurance that cover in case they run away without paying rent + sue their butt off legal fee.

 

Which area is this at?

I'm a big fan of REITs too. Do you pay cash for your REITs shares or use leverage? Without leverage, it is quite hard to generate a significant enough income to make them meaningful.

$100,000 cash would just generate ~$5,000 pa without leverage.

Other than good capital growth and low vacancy rates, why do you prefer your RIPs over your CIPs?

 

Do you check your tenant's financial statements before "letting them in"?

What is a correct retail property for you? Would traffic be the #1 factor in retail?

 

The key risk isn't the tenant itself, but selecting the correct shop which it has to be high demand or have potential high demand. What that translated to be is you do not have to care what the financial position they are in, but you can find the next tenant as long as they breach their contract. of course make sure you reduce your risk by buying insurance and selecting an real estate agent that is proper.

It is hard to check their financial as they can have a lot of cash in their account, but their business can make the lose it very quickly if their business isn't taking off. So, it isnt a really good way to reduce your risk, and can only use it as a compensating control.

The correct retail property is of course
1. within my capability to buy, as it wont used all my cash, so I wont be able to pay the commercial loan if there is a extended period of vacancy period
2. have potential to increase rent massively. that require to wait pretty much patiently. The best is the first term are around 1-3 years to go, and you can foresee higher demand once in 1-3 years time. Not to mention the banks love the current lease to have some remaining so they are more comfortable to lend it to you. If the first term is almost finishing, the banks are less willing to lend you. May not even lend you at all.
3. if 2. isn't the case, then make sure you find some where already have a lot of traffic but potential to add value. e.g. add a level, partition the shop into 2 smaller one, change usage and etc.
4. the last rule is the most important, never over paid. I like the 5% ROI rules, if a shop is in a really busy place, I can accept the 5% ROI, so, if the shop is renting with 50K net, I will pay 1 mil. Provided I know once the shop finished it first term, I can say increase it to 75K-100K. The better could be you do things that add value and jack the rent to say 15% ROI. then you shop will worth around 2-3Mil by then.

 

I prefer RIPs for these reasons
- easier to finance, less capital outlay required
- can value add via developing
- can be sold/rented with an emotional uptake by lessees/buyers. If they feel an emotional connection with the dwelling they will pay more
- shorter amount of time to find tenants (generally)
- no incentives/fitout

With a CIP the value is often intangible with the value of the lease. The better the lease is the more the CIP is worth. If it's vacant then selling it can be a big issue.

CIP Lessee financial statements are either kept low by their Accountant for tax purposes or made too high for themselves to get finance for something. @wooster explains it well that a good tenant is nice but a great location that will have other tenants vying for it or happy to come in quickly is king.