Thoughts on investing in commercial vs buying residential

Based on your experience and @wooster, it seems vacancy rate is the biggest killer to a CIP.

I read financial statements pretty easily as the majority of my portfolio is in businesses/shares. I can spot businesses that are dying vs businesses that are cash cows (who can pay rent easily) but have low profits because of tax reasons.

In regards to your RIPs, what is the cash flow like? Because from my numbers, (I'm in Melbourne), the yield is terribly low and investors are counting on capital growth to justify holding those properties. What if when the market goes flat? Thoughts?

Even at 6%, the yield would be too low, no? Unless you have a million dollars

I can't seem to wrap my head around REITs without leverage because generally, REITs have high yields but lack growth in share price and fundamentals.

VCX has been flat for the past 5 years. SCG up 20% in the past 5 years. Mirvac is one of the better ones.

Thanks for the great answer, wooster.

What do you mean by high demand? What would you consider high demand?

Are there insurances that cover the loss of rent in the commercial property space? I think that would solve a lot of vacancy rate issues with CIPs.

How much buffer do you allocate for your vacancy periods?

Regarding your rental increases in your example, wouldn't a big jump of $50k to $75-$100k turn tenants off? Wouldn't a 3-4% increase in leases every year be a better way to increase rents and the valuation of your shops?

 

High Demand is in fact a really hard concept to get, but in general I think.

1. close to public transportation, like say within 5 mins walk
2. close to place that a lot of people live in, or work in. If there aren't a lot of people that live in, then make sure the people live in there are rich, so the business in there can charge a premium and in term can afford higher rent.
3. a tourist location is always on high demand. e.g. the beach, or place with popular sight seeing.
4. a place that are already popular with a certain type of business, the best are full of restaurants, like a eat street. Having said that, 4. should combine with 1. as I have seen a lot of place that does not close to transportation and eventually, the restaurants business will die down.
5. a place that have a high concentration of group of people. e.g. china town, indian town, korean town, etc etc(no so sure about japanese town though), well can be hipster town too , the theory is people tend to stick together.

Insurance is for covering if the tenant dont pay rent, not for if you shop is vacant, dont think there is insurance for shop is vacant.

For buffer, it is hard to say, may be 2 years of repayment? the best is your income can cover repayment, so you dont have to rely on saving, but well you can't be sure if you are always being employed.

3-4% is a must, I find in general it is 4%, the more popular your shop is, the more negotiate power you have. so what you really want is both, so 4% pa increase + rent jump when the term ends. else, the value of CIP go up very slowly, i.e. 3-4% pa which is rather very not exciting(for me I would say). well may be I am just greedy . otherwise, isnt resi better than? think of the capital growth of resi.

 

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It's a general expectation but I've seen rents are reduced significantly when leases are renewed to match it to market rents. (from $135k to $115k).
I have a friend who bought a shop returning $8k per month in 2008 but now it's returning $5k only.

Also, don't forget the landlord's contribution trick. I've seen a cafe listed for sale with $160k rent but the landlord contributed $400k for the fitout. You know what will happen when the lease's up for renewal.

Fitout period and Rent free period needs to be taken into account as well. rent free are generally just one month per one year contract period but the fitout period can be as long as 6 months depending on the type of work required.

 

Agree, so I guess I forgot to mention when looking at the shop, you need to watch out for how much potential it has already been used, example could be a shop that current has a tenant with a very good business, paying above the market rent. I normally do not go for those shops as I know the selling price would be high, and the shop has already used its potential. If that shop is below market value then of course it is worth it.
To know what level of potential the shop has been used is also a hard concept, as it is then not a simple 5% ROI rule, lets say a popular place,

a. a shop has a dodgy tenant paying below market rent, and if you can buy it will 5% ROI, you hit a jackpot.
b. a shop has a superb tenant paying above market rent, and if you buy it will 5% ROI, you are potentially making a loss

Try to think of it this way, an retail that is already A Grade could have potential to become B or C grade.
B-C Grade have potential to become A Grade or remain as B-C grade. The difference is you pay Top $ for A Grade, where you pay way less for B-C grade. Having said that, when the economy is bad, or you are very lucky you may also be able to secure an A Grade without paying top $, but that's a topic of luck.

If your shop is in a popular area/ potential to be a popular area, I dont think you have to contribute $ for their reno, but you do have to give them some rent free period for reno. Depends on how popular your shop is, and the location, can do 2 months free in the first year, then 1 month free in the second year.

 

I develop properties so my yields are higher than buying just a "buy and hold". To increase yield you need some sort of value add that will give you extra bang for buck in the good and bad times - renovation, subdivision, short term let. The market in Perth is flat at the moment but I'm down to 4% yield which goes up to 6-8% in tight rental market times.

 

I was thinking more along the lines of small CIPs like retail and offices with SMBs. Even though they might not be as safe as ASX-listed companies but a lot of SMBs generate significant cash flow where rent is < 10% of their sales.

When you invest in REITs do you buy their shares on the ASX or go direct? Any huge pros and cons between them?

Looks like adding value applies both to CIPs and RIPs. Do you see much opportunities to add value to CIPs? For example, a warehouse, how much value can you add to a warehouse or an office space on the 23rd floor?

In regards to tourist location, wouldn't the business be very cyclical and your tenants would be the same too which could affect the vacancy rate? Or do you find tourist locations better than the average?

Regarding people sticking to together, that's a very good point which a lot of people don't bring up. The activity is always much higher in locations where there is a high concentration of a certain group of people regardless of income.

For your buffer, wouldn't that be a huge opportunity cost when you have 2 years repayment? What do you do with the $?

A similar investor (Howard Marks) also said a similar thing regarding junk bonds vs AAA bonds. The only way AAA bonds can go is down. Junk bonds on the other hand since they're junk status, the only way they can go is up. The main question now is how risky the junk bond is?

How would you measure whether a client is B or C grade just by looking at their company name? Because maybe a no-name real estate agent might be a much better tenant than Dunkin Donuts.

 

I have never buy anything in a tourist location, I cant really afford as most of them are really expensive. Having said that, it will depend on what tourist location we are talking about.
e.g.
a. snow mountain, yes very cyclical, which I have never think of I would want to go for.
b. Bondi beach/Manly beach/coogee beach. I think its not that cyclical, you can say in winter the business is a bit quite, but I doubt if there is a big difference.
c. The Rocks/Crown Casino. 365x7 super busy!
Are they better than average, I think the good thing is it will be very easy to rent out as long as you charge market price, so as long as you dont pay overprice, then yes I would say better than average.

For people sticking together, I forgot to mention around well known university is good as well. Uni Students needs to spend too.

In terms of buffer, you can buy blue chip share or investment that is quick to turn around and not too volatile, remember for commercial the bank can call loan if they need to, it is not like resi where banks are less likely to call loan. During the GFC the banks call back a lot of commercial loans and you may then forced to sell your top commercial properties cheaply which is something you would never want to do. A little sacrifice sometime is needed. Well not to mention when the other go busted and require to sell their top properties, you may be able to buy those up, since, you have good level of capital buffer.

For the question of how risky, it will really depend on how well you know the area, I recommend to read news/gov website to find out the current improvement to the area before you are buying.

a. new train line, new hospital, new shopping centre, and etc.

b. If it is a busy place, how possible is to add value to the property. lets say currently is a hair salon and rent is average. Will there be a possibility to change usage to a restaurants that can satisfy the people living in the apartment blocks around the shop? if it can how much rent can it increase?

c. if it is in a busy place, and you are buying a shop top housing with 2 floors, will it be possible to add an extra floor ? all level with their own entrance? if yes, can we rent the ground level out to cafe, 2nd level to hair salon, and 3rd level to be airbnb? if yes, how much rent increase compare to just renting the original 2 levels shop out?


In terms of A, B, C grade, it really have nothing to do with your tenant, but the potential of the shop. As above, B/C grade is shop that is cheap but with potential to add value, or area will improve after few years/people start sticking around that area. A grade is already in a busy place where it is easy to rent out, good rent but lacking the potential to grow within few years. Having said that, if the economy is bad/owner need cash quick, you may be able to pick up A grade with a bargain price but that's either because of luck/you have a large amount of $ buffer.