Are bricks and mortar for you?

With property prices appreciating at record levels, not surprisingly, real estate is piquing the interest of many who haven’t traditionally invested in bricks and mortar.

If you’re pondering property, one of the first considerations is: which investment best suits your budget – and risk sensitivity? Residential, commercial, or, perhaps, a mix of both?

Fundamentally, as with most investments, the basic issue is one of risk versus reward – while a commercial property investment is, generally, more risky, the paybacks are, often, significantly higher.

Here’s some food for thought as you decide the merits of each.

Let’s look at commercial property

The “pros”:

• Under the standard lease of commercial premises, the tenant is required to pay most outgoings, such as rates, insurance premiums, maintenance of building services, etc.; whereas, a landlord pays those costs in a residential tenancy.
• The tenant is committed to leasing the premises for a longer term – often five years or more. Residential tenants tend to turn over more often.
• The directors and shareholders of a tenant company are generally required to give personal guarantees; so, if there is a default, the landlord can chase individuals, as well as the company, for any outstanding rent.
• An owner can claim depreciation on a building fit-out in commercial premises.
• The returns are usually significantly higher than those on a residential property.
• There are regular rental increases (every two years, commonly), and the standard lease forms prevent the rent following a rent review from dropping below the rate at the commencement date. There is also the potential to negotiate fixed increases or increases in accordance with CPI growth.

The “cons”:

• The landlord will have to register for goods and services tax.
• The purchase price of commercial premises is usually higher than a residential property.
• There is a risk that a tenant’s business might fail, in which case the landlord would have to find a new tenant. It can be harder to find a new tenant for commercial property, particularly if the economy is not doing well, compared to finding a new residential tenant.
• It tends to be harder to sell an empty commercial property than it is to move an empty residential house.
• The landlord might have to spend money changing or improving the premises to attract a new tenant if the existing tenant leaves.
• Banks will lend a lesser percentage of the value of a commercial property than for a residential one.
• A commercial loan will normally have to be repaid much earlier than a residential loan.
• The interest rate for a commercial loan is higher than that for a residential loan.

What about residential property?

Pros can include:

• On average, it is cheaper to buy a house to rent out than it is to buy a commercial property.
• Normally, the owner will not have to register for GST.
• A residential tenant is usually not involved in business, so there is less risk of them not being able to pay the rent because of business failure.
• It is easier, generally, to sell a residential property that is vacant.
• An owner can, typically, borrow a greater percentage of the value of residential property from the bank, the interest rates are lower, and the term of residential loans tend to be longer.

And, now to the cons:

• The overall returns are, on average, less than for a commercial property.
• The owner has to pay outgoings on the property.
• There is more regulation of residential tenancies than commercial tenancies.
• If a tenancy has a fixed term at all, it is usually for a much shorter duration than a commercial tenancy.

Commercial property investment hints

1. If you are looking at buying a commercial property, you should make sure that the property is not “over-rented” - that is that the rent being paid is higher than the market rent. This is because the value of a commercial property is largely based on the rental return, so if the property is over-rented there could be no rental growth for some time and, therefore, no increase in the value of the property. A valuer could be asked to assess whether the rental being paid is the current market rental of the property.
2. To increase the chances of finding a new tenant for a commercial property when a tenancy comes to an end, it is important that the property is in a good location. It tends to be easier, too, if it has not been designed for a specific purpose (e.g. a fast food outlet), which can mean slimmer pickings and more expense when it comes to securing a new tenant.
3. The vast majority of commercial landlords use the Auckland District Law Society Deed of Lease form, which is intended to provide a fair balance between a landlord and the tenant. The clauses in the standard form are often modified, however. When buying a commercial property, it is important to make the agreement conditional on carrying out due diligence, including reviewing the lease terms.
4. If you are looking at a commercial property investment, you should also consider the development potential of the site, and what uses are permitted under the applicable zone in the council’s district plan.
5. While the value of a residential property is generally driven by the supply and demand of home owners and investors, the value of commercial property is greatly influenced by the general economy. Generally, during good economic times, businesses are growing and expanding and need more space, so it is easier to find tenants and rentals increase. During slower economic times, however, there are fewer tenants, who tend to need less space. Rentals don’t usually increase in a downturn – and can actually decrease – so make sure you go into any investment with your eyes wide open.