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In the current climate, is commercial property a good investment?

In the current climate, is commercial property a good investment?

In this week's episode of the Tell Us What You Really Think podcast, Sean and Anthony chat about the pros and cons of investing in commercial property, and how the market has changed over the past decade to become more accessible for the average investor.

They also cover the boom and gloom of the Australian property market and how things are shaping up after the election.

Hopefully, this episode will demonstrate to listeners how commercial property is similar to residential investments, and why it's an area with massive potential.

Episode 12 Transcription

Anthony: (00:00)

Welcome to the podcast. Tell Us What You Really Think, we're Sean and Anthony basically here just to tell you what we really think. We cover all things property, finance, and technology, and we are brought to you by www.ratetracker.com.au.

Sean: (00:16)

Anthony. Welcome back to the podcast.

Anthony: (00:19)

Thank you kindly.

Sean: (00:20)

It is official. The RBA's first rate rise in over a decade.

Anthony: (00:28)

Yeah, in 11-12 years!

Sean: (00:29)

Juicy, juicy times. The cab has left the rank! We'll see what happens in the next few months.

Anthony: (00:38)

For sure.

Sean: (00:38)

There's a bit going on, but what we need to do is focus and be mindful of the actual facts, as we know. Don't get too caught up in the media narrative around it all. Just mind your own person and keep pushing on. So, what are we gonna be talking about today – to shine a light on both the positive and negative things happening in the property space? What are the hot topics?

Anthony: (01:05)

Yeah, for sure. So we're going do things a little bit differently this episode. We're going to focus on one topic for the duration of the episode, and it's something that we deal with day to day. It's definitely evolved over the years. It's an age-old debate, what's better to invest in – residential or commercial property?

Sean: (01:24)

Wow.

Anthony: (01:25)

It's definitely evolved and changed, and we're looking forward to debunking some misconceptions.

Sean: (01:33)

Yeah, definitely. Firstly, we'll look at Australia's property update, the boom or gloom segment. Then we'll look at what's up with commercial property? What's your opinion on it? When you say that it's evolved, it certainly has evolved. When I was younger, I always thought commercial property was something that older people business people and business owners did. You know, the mechanic down the road owning his workshop or the shopkeeper at the milk bar owned the old building. And that was that, everyone else owned houses instead What was your perception of commercial property?

Anthony: (02:08)

Yeah, definitely. It always seemed like commercial property was for sophisticated investors – people with a lot of money – or business owners that needed to run their own businesses out of the space. It really seemed outside of the reach of your mum and dad investor. Your everyday investors were typically looking at residential as the only type of asset class to invest in the property market. Commercial wasn't seen as a viable option. And there's a few reasons why that was the case, but it's definitely evolved.

Sean: (02:37)

Yeah. I always thought that it had to have utility. Like, if you were going to buy a commercial property, you needed to use it. And that's just completely not the case.

Anthony: (02:45)

There are a lot of different rules and regulations around both asset classes, and that's what we'll go through today as well.

Sean: (02:51)

Beauty! Looking forward to it. First off, as we start every episode, we will go through Australia's property update. Boom or gloom! How are we looking?

Anthony: (02:59)

Interesting times! As you mentioned, rates have gone up and for the first time in a while. It's funny how it definitely affects people's perception of things.. I imagine that the media 11 or 12 years ago weren't as frantic or confronting as they are now.

Sean: (03:19)

And the speed at which they can spread news is obviously a lot faster. You used to watch the six o'clock news to get that information.

Anthony: (03:27)

Now you can just open up your phone!

Sean: (03:28)

Even a decade ago, Facebook wasn't seen as a media tool, it was just a social network. So even when the rates were rising from the GFC throughout 2010–2012, we only saw it on the news and in newspapers. You didn't get information in your face 1400 times a day through the 14 different social media platforms that you use.

Anthony: (03:52)

Yeah. I remember starting off in the industry then, and all you knew was that rates were going up.. And it was just like okay, I guess that's what's happening. So what's happening in the property market at the moment,? tI's definitely paring back a little bit. So that's what we're seeing now is auction clearance rates reducing.

Sean: (04:08)

I did see that.

Anthony: (04:09)

So, they did peak at about the time last year, at about 74-75% clearance rates. Now that's dropping down to low sixties. I believe Melbourne was at 64.6% overall, and then there was a revised figure down to 63%. So that's down by over 10%!

Sean: (04:33)

Let's break that down. I know that it's going to sound really simple to a lot of people that are really pro-property and follow it closely, but let's talk clearance rates. Assuming 1000 properties hit the market and go up for auction on the weekend. How many were taken to auction in Melbourne?

Anthony: (04:51)

895.

Sean: (04:55)

And how many were taken to auction this time last year?

Anthony: (04:59)

1400. So the volume is down.

Sean: (05:05)

Yep. Massively. That's a big jump.

Sean: (05:09)

Yes, 1400 last year. And 1,290 last week. Let's assume that people are going for the 4-week advertising campaign. The numbers are down and effectively only half the people are getting the results they want.

Anthony: (05:29)

Yeah. So that's a telltale sign that the market's coming down.

Sean: (05:35)

It'd be interesting to see what happened with those properties a week later. How many went out and renegotiated with the top bidders...

Anthony: (05:41)

Which is something that we're seeing a lot of! There are a lot of clients that go to auction and buy after the fact, which probably doesn't reflect in those figures. Yeah. But still that frantic volume of auctions...

Sean: (05:50)

Noone's got the guts to put their hands up on the day. And hey, I'm all for this– because it means our buyers can take a step back and watch it get passed in and then go in and start with a reasonable price, naming their price as opposed to being up against 5 or 6 different hands.

Anthony: (06:08)

Yeah, for sure.

Sean: (06:10)

Very good. Looking at the statistics for capital cities, as far as growth goes, we did see that we are effectively at parity. So I think last month was the first month that was below 0.5% growth. It'll be interesting to see next month, whether or not we do get any growth. Whether it's going to be a positive figure or a negative. I think it's gonna be the first negative simply because of those auction clearance results.

Anthony: (06:43)

Yeah. And it's just so interesting to see that Canberra and Adelaide are the best performing auction results in terms of cities. Adelaide's at 81%, so Adelaide's humming. Canberra's at 75% – we've got a lot of exposure to Canberra through our clients – and that's really flying. And then when you are looking at somewhere like Sydney, it's down to 58% clearance rates. Sydney have had massive growth for a very long time.

Sean: (07:12)

Canberra's a funny one too, because you can still find some cheap property in Canberra. But at the same time, their market is so diverse. You can still find first home buyers buying properties at $550,000-$600,000. And then you've got the other pockets where you can't buy anything under $4million. It's an interesting city.

Anthony: (07:32)

Yeah, for sure.

Sean: (07:35)

Mate, let's jump into the topic of commercial versus residential. How has it changed, and what's the major difference between the two asset classes?

Anthony: (07:46)

Yeah. So just breaking it down and comparing the pros and cons. Typically residential has a lower rental income based on the asset value – which is called yield – than commercial, but historically residential has had better growth over time. So you earn less income, but you have better growth. Whereas commercial has better income based on the asset value, but not as much growth. Typically, tenants are actually in the property for longer than residential properties. So residential properties are usually on 12 month lease terms, and they typically last one cycle and then they can exit really easily.

Sean: (08:29)

Too easily, these days!

Anthony: (08:30)

Now they can just walk, and pretty much just throw the keys in. Whereas commercial you're getting tenants for 3, 4, 5, even 10 years.

Sean: (08:37)

I remember chatting to the guys in the commercial leasing team at CBRE and they were saying that now the leasing terms are getting more flexible. However now, rather than signing up for 10-year terms, they're doing a lot more, 2 x 2 x 2 x 2 x 2. So it's 10-year terms, but with 2-year review periods, which also helps the property owner. Back when you used to have a 10-year terms, you set the price, but you didn't know what the price of the rental was going to be in 10 years time. So now, all those old leases are coming off and the owners of these commercial properties can review their terms more frequently. You don't have to go into bed with a tenant, which is great. You could have a really strong, long-term tenant, but you weren't allowed to review terms. You just got your CPI increases.

Anthony: (09:24)

You were just stuck in it!

Sean: (09:26)

So that's good that they can now get a little bit more. Maybe that will change what you were talking about earlier in terms of rental yields being stronger for commercial.

Anthony: (09:35)

So you know, if you're looking at commercial, you're going to get a return anywhere between 5% - 8%, But some of those numbers have been compressed in recent times.

Sean: (09:45)

So again, let's just put that into real simple terms. For a $1million property to put things in round figures, you are earning $50,000 to $80,000 in commercial income. For a $1million property in residential, you could be earning anywhere from $20,000 to $40,000. So that's less than half the income.

Anthony: (10:01)

Yeah. And that's at a very high level, basic assessment of those asset classes.

Sean: (10:10)

Very good. So next up, commercial interest rates. I think we'll probably cover it in a little bit more depth, but the commercial interest rates now aren't very different to residential.

Anthony: (10:22)

Pretty much the same. They used to be a lot higher.

Anthony: (10:26)

They used to be 1%-2% higher. So pretty much similar rates with the banks.

Sean: (10:34)

Very good. So give us a rundown of how you would set up that funding position for a residential versus a commercial facility.

Anthony: (10:46)

Yeah, sure. So with residential and commercial, they're actually quite similar in terms, but so just to give you an example: With residential property, you can borrow up to 90%, but typically most of our clients borrow 80% of the value. So if it's worth $1million, they're borrowing $800,000, and interest rates at the moment are starting from around 2.5%.

Sean: (11:09)

After the rise, yep!

Anthony: (11:10)

After the rise and the loan term, and the repayments are calculated based on 30 years. So that's the metrics for a residential loan. Now commercial loans, they used to be only on 15 year loan terms. You could only borrow 70%, so you'd need a 30% deposit. And the interest rates would typically be 1% higher. Therefore it'd make it really hard – from a cash flow and a deposit point of view – to make it work, because the repayments were going to be higher. And you're going to need a lot more funds.

Sean: (11:51)

So maybe that was what was pushing everyone out.

Anthony: (11:54)

And that was the case up until about 3 or 4 years ago. But interestingly, now commercial falls in line with residential. So, it is a 30 year loan term and you can get interest-only with commercial now, the same as a residential investment property. Most clients do interest-only, whereas it used to be 15 years paying principal and interest. And, you can now borrow 80% for commercial, which is phenomenal. The terms are similar to that of a home loan.

Sean: (12:27)

Yeah. I think that probably removes a lot of those barriers that everyone was used to. I think you used to have to review your commercial loans as well? Every 2-3 years you had to send in new financials and supporting documents. Now they're set and forget, so you can set the loan up over 30 years, no worries! You can just make your payments and no one will hassle you.

Anthony: (12:48)

Absolutely. It's a lot more attractive.

Sean: (12:53)

Looking at the growth side of things, there's an enormous number of factors that come into it. If you had bought a commercial property in Dandenong 10 years ago, you probably would've got more growth than you would have seen in a residential property. However, if you bought a commercial property in Broken Hill, or the middle of Australia somewhere, you probably haven't seen much movement in that 10 years. So it's too difficult to say residential verse commercial by just putting them side by side.  

Anthony: (13:22)

From a growth perspective, it's hard.

Sean: (13:25)

There's too many variables depending on where you buy, what you buy, who your tenants are, what's happening in the local area. Is there a massive push to create business hubs - like in Frankston and Dandenong – where they've now got massive business hubs?

Anthony: (13:38)

Like satellite areas.  

Sean: (13:38)

Yeah, the people lucky enough to buy commercial properties in those areas 10-20 years ago, they're gonna do really well out of those spots. For sure. Give us a rundown of how to buy a commercial property now – a nice clean example.

Anthony: (13:59)

So to put them side by side, let's go back to that analogy of a $1million purchase. In both scenarios, you would need a deposit of $260,000.

Sean: (14:10)

Which covers stamp duty and everything.

Anthony: (14:12)

A 20% deposit and stamps. But then when you're looking at some of the other metrics, such as residential income on that property, let's go with a midpoint of residential income of $30,000 a year, which is 3%. For commercial, I've actually gone to the bottom end, which is $50,000, or 5%. So you're $20,000 grand up on income per year on the property. So whilst interest rates used to be different, they're now pretty much the same. In terms of expenses, this is where it gets interestin, because with the residential property, the landlord has to pay all the outgoings and expenses, not so much the utilities, but rates, maintenance, insurances. So typically, we've used a figure of around $4,000 to cover that. Whereas on the commercial side of things, it's all paid by the tenant. All the outgoings are paid by the tenant, including rates, insurances, land tax.

Sean: (15:24)

Okay. So it's a no-brainer that anyone who owns a home and a residential investment property should probably be looking at diversifying into some sort of commercial asset. Looking at those numbers, what can make commercial property a better solution is the fact that you could pay principal and interest, and the rent would cover the repayments. If you held it for 15, 20, 30 years, you could pay that loan back entirely and have a cash cow set up for your retirement. As opposed to a residential property, where it's still more labour-intensive and expensive to hold onto. Obviously we've had record low rates recently, but you can't afford principal and interest repayments on an investment loan on residential rent alone.

Anthony: (16:14)

Correct.

Sean: (16:15)

Very few of these cases work, unless you're at 60% or below. Now the commercial space, you can probably get a 80% commercial loan. The rental income will likely cover the entire repayment on a principle and interest basis. You'd be mad not to pay that off.

Anthony: (16:30)

Yeah, if you're getting returns of 5% on your commercial property and paying a commercial investment loan of 3.5%, then the income's more than the interest. So you're gonna be ahead. We've done the calculations and you'll be ahead by about $25,000 in this scenario with a commercial property.

Sean: (16:51)

Is there anything you can think of in the commercial space that people should be wary of – in terms of commercial property and investment?

Anthony: (17:00)

Yeah. For commercial property, location is going to be the key, as well as the type of property. We haven't seen great success with retail in the current environment.

Sean: (17:13)

Yeah, like Bridge Road (in Richmond).

Anthony: (17:14)

Yeah. People aren't leasing out those assets at the moment, but in terms of manufacturing and industrial spaces, there's a big push from the government to bring manufacturing back into Australia. They're building a whole range of distribution centres out in the Western and Northern suburbs.

Sean: (17:35)

That's where Coles and Costco have taken up their massive spaces.

Anthony: (17:42)

There's a big shortage of industrial land. So even if you're buying one of those little factorettes for $500,000-$1million, we've seen great results and really good returns. It's a great alternative to residential.

Sean: (17:59)

I had a client looking at a factorette – which I'd never seen before. It was basically just somewhere he could park his truck because he leaves materials on the back of his truck overnight, because he leaves first thing in the morning. So he is buying a factory for around $200,000 next to the Monash. Basically, it means he can drive his car to the truck that already loaded, so he can start the job first thing in the morning. And these things are just side by side, there's about 30 of them in a row! And they're cheap! $200,000 and you can literally fit one truck and that's it.

Anthony: (18:37)

Yeah. And often they just like a little office on the top mezzanine. So they could use it as storage, they could use it as a warehouse or office. And if you 're looking at factories near Monash or an apartment block down the road, I think I know what type of asset I'd go for if I had the money. And look, we need to preface this by saying that this is not financial advice or property advice. This is only what we've seen. But yeah, just looking at these two types of assets for the same price point and 9/10 times people would consider commercial.

Sean: (19:17)

No, definitely. I think it's an awesome space and it's good to see it evolve and become more in line with residential policies and a residential approach to lending. So we'll see how that evolves. And like I said, it's good to consider diversifying your portfolio and trying to add some different exposure with different risk assets.

Anthony: (19:38)

Agree.

Sean: (19:38)

Mate, that's good. That's a good wrap up of the evolution of the commercial property space. I think that with everything going on with interest rates, it's vitally important that we keep a very close eye on things. Look at your overall risk, make sure that you're two steps ahead with your thinking, look at all the different possibilities and where you're going with your investments. Just be careful out there as things may change in the 2022 financial year.

Anthony: (20:18)

Yep. Agree. And just factor in potential rate rises, but don't get too caught up in it all, because as we've noticed from three months ago to now, things can change.

Sean: (20:30)

Definitely. Awesome! We hope you enjoyed the episode brought to you by ratetracker.com.au. And probably the most important time get around RateTracker. Jump on the website and have a look at the 30-day interest rate tracking technology. We'll review your rate and compare it against the industry benchmark every 30 days without you having to worry about it. It'll only let you know if your rate ever creeps above the threshold. We hope you have a good week and we'll chat to you again soon. Thanks a lot!

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