With residential prices cooling considerably in the last 18 months it stands to reason for investors to consider commercial property for higher yields and potential capital growth. The different parameters in this area can, however, be tricky for the uninitiated. Current market conditions dictate that research into the best markets to buy, as well as the tenant profile of the building, is more important than ever.

Anthony Bray, Department Head NSW of sales and investment at Cushman & Wakefield says the major factor determining an investment is risk profile which means looking at weighted lease expires, the term used to measure a property portfolio's risk of going vacant.

“Property with short term weighted lease expiries (WALE), in most cases will attract a higher yield or a lower price in comparison. Benefits of a short-term lease will only benefit an investor if the property has a readapted use – i.e. redevelopment potential and the purchaser have a development background to extract the highest and best use. It may also be that the existing tenant is not the most desirable however, the location will attract a much better-quality occupant increasing rental income, lowering the risk profile and increasing the building value.”

Among other factors to determine, here are some that need to be asked:

1. Are there any pending or outstanding lease renewals?

As rental income is clearly imperative for a property to be deemed an investment, lease renewals or any negotiations for new property lease periods will always improve the potential value of a building and lower the risk profile, Mr. Bray said.

“However, a tenant exercising their option may not be seen in the eyes of an investor as a positive, as many people seek investments with new lease terms including additional option periods. In short, a tenant entering an option is only secure for the option term and provides no guarantee for any period beyond. This increases the risk profile. However, a new 10-year lease with 10-year option lowers the risk and the yield increasing the potential overall value.”

2. What is the payment history of existing tenants?

Investment properties secured by national brands or publicly listed companies generally present a very low rental payment risk. But when the rental payee is a small local operator, the landlord is reliant upon personal guarantees and goodwill said Mr. Bray. Asking for payment history records in these cases is a good idea.

“Payment history records have been requested for assets where the tenants have not been of a national level and the purchaser or their lender are concerned over serviceability,” he said.

3. Is the yield commensurate with the wider market?

Dig deep into all the figures associated with commercial properties in your chosen area. Commercial property values vary in many of the same principals as residential property. If you desire to own a property at Bondi Beach as opposed to Bathurst then the price variances and yield spreads are extremely different.

“Bondi Beach retail will command very high rates per square metre and have demonstrated yields as low as 3% and lower, whereby comparison Bathurst being a developing inland city will most likely reflect yields of between 6.0% - 10.0% depending upon the profile,” Mr. Bray said. On the flip side, the end property value in Bondi may be 10 times more than that of Bathurst. Also, while the risk profile of a Bondi property would generally be considered as lower than premises in Bathurst, an investor there could also strike a similar lease profile with, for example, a major bank or fast food chain outlet as a tenant.

4. What kind of commercial property is best for my situation?

“If you are a first-time investor into commercial, try to invest into a national brand where the lease terms of agreement protect against any unexpected expenditure and terms of tenure are 3 years and over,” Mr. Bray said. “If the building in which you are investing is of good quality, has a re-adaptive use and a quality tenant, then your risk is lowered and hopefully the investment is sound.”

 However, if the risk is high Mr. Bray warns to extremely careful. “Have a lot of money to protect against potential long periods of vacancy and make good to attract the next incoming occupant,” he said, “Agent’s fees are also very expensive and are determined by the tenure of the lease.”

5 How much can I borrow?

The challenge at present is the ability for people to borrow. “Lending criteria for commercial property are very different to residential and the banks generally require a much greater deposit,” Mr. Bray said. “Depending upon the lease profile or the buildings potential the banks may require up to 50% equity from the borrower – which in most cases is unobtainable.”

Many purchasers up to circa $5 million are Self-Managed Super Funds. “This form of lending has been a great support to the commercial sector, but since the Royal Commission into banks occurred, most financial institutions have stopped lending in the light of APRAS more stringent new conditions,” Mr. Bray said. “Without the SMSF’s, the commercial property market has eased, but many transactions are still occurring.

“Commercial property provides a true return on investment that is property measured.”