She says the higher income flow she’s receiving has made her optimistic about her ability to retire when she wants to. “Retiring now is not a scary thing for me.”
Damian Collins, MD of property investment advisory Momentum Wealth and CEO of Westbridge Funds Management says residential property is a good place for investors to start.
Growing up in a home where property investment was frequently discussed, Chebab, a first-generation Australian whose parents migrated from Lebanon, says she followed the well-trodden path of buying a home and then a residential investment property.
But according to O’Neill and Damian Collins, founder and managing director of property investment advisory Momentum Wealth and chair of property fund manager Westbridge Funds Management, the path Chebab followed into commercial property investing is a great model.
With lower technical and financial barriers to entry and the strong opportunities for capital growth, they say residential property investment serves as a great starting point, but once approaching retirement most investors would be better served switching to commercial property.
“My philosophy on this is residential property is a great place to start but commercial property is where you want to finish up – a blended portfolio of both is the ideal model for retirement,” Collins says.
“We recommend our clients to start in residential but then move to commercial as soon as it’s viable to boost cash flow to replace incomes because you simply will not build a great retirement income from residential,” O’Neill says.
The benefits of commercial property for retirement
Collins says the key benefit of commercial property is that the net yields are higher than residential property, with a range between 5-8 per cent depending on what and where you buy. “At best you’re probably going to net 3 per cent on residential property after expenses in cities like Perth, Adelaide, and maybe Brisbane, and 2 per cent in Sydney and Melbourne.”
Part of the reason for the stronger net yields is that all maintenance costs in commercial properties are borne by the tenant, and, depending on the lease, property management costs can also be passed on to them.
Annual rent increases are also usually built into commercial lease agreements, which typically run for five years, another plus according to O’Neill. He says the value of commercial property is also, in part, dictated by the quality of the tenant, meaning that owners can increase the value of their property by increasing the rent, lengthening the lease or attracting a larger or more prestigious tenant.
“There are fewer headaches generally with commercial,” Collins says. “When it’s not leased, it might sit vacant for a long time, but generally when it’s leased it’s a lot easier to manage.”
The downsides of commercial property investment
As with any investment, there are trade-offs – commercial property is considered a riskier proposition than residential. “It does carry more risk. That’s why the returns are a bit higher,” Collins says.
Scott O’Neill, MD of Rethink Investing says much of the risk posed by commercial property investment can be mitigated.
While Australia is undergoing a residential rental crisis with low vacancy rates, even when the market is softer it is “very rare” in a capital city that you wouldn’t be able to rent out a residential property, Collins says. But if a commercial property market goes south, as is happening with CBD office space after the pandemic-led working from home boom “you might find that it’s vacant for a year or two or even longer”, he says.
However, O’Neill says much of the risk can be mitigated if you know what you’re doing, or get expert help. He says picking the right commercial property takes some business acumen and requires a lot more due diligence than buying a residential property.
The cost of entry is also a barrier to commercial property investing for some. While a residential property can be bought with as little as a 5 per cent deposit, commercial buyers need a 30 per cent deposit.
Besides the higher deposit required, quality assets usually come with a higher price tag. Collins says buying a cheap, high-quality commercial property is virtually impossible. “It’s very hard to buy good-quality stuff at the low end.”
He suggests that in Sydney buyers will need $1.5 million-$2 million, while in other major capital cities, $1 million may be sufficient. “You can get assets below that, but they’re going to be generally secondary and/or very small. Ultimately, your commercial asset is only as good as the tenant you get into that property.“
O’Neill says that in the case of warehouses, it is possible to pick one up for $600,000-$700,000. “Based on a 30 per cent deposit plus costs, I tell my clients they need at least $200,000 to start looking,” he says.
But O’Neill says the correlation between cost and risk is strong in commercial property with a higher price tag usually translating to a lower risk. “It means you’re dealing with ASX-listed companies as tenants compared to local trades businesses that might move every two years.”
O’Neill says there is also a perception that commercial property doesn’t provide much in the way of capital growth. But he says figures from the past 30 years show that the capital growth rate on commercial property was only 1 percentage point lower than that of residential property.
“So overall, it works out to be about 11.5 per cent when you add the cash flow and the capital growth together. The average yield and growth on residential was about 8.5 per cent.”
Accessing commercial property via a fund
Another way for investors to benefit from the stronger yields generated by commercial property while offsetting some of the risks is to invest in a commercial property fund, rather than directly.
Property funds offer a lower entry price, with no minimum buy-in required for listed real estate funds, which trade like shares on the stock market. However, Collins says the volatility of listed property funds turns some investors off. “For a lot of people, that sort of defeats the purpose of being in property because it’s meant to be less volatile.” He says minimum buy-ins for unlisted property funds are set by the fund manager but can range from $25,000 to $500,000 or more.
Property funds also offer increased diversification, Collins says. “The downside [to direct investment] is obviously concentration risk – you get no diversity if you’ve got one commercial property, that’s all your eggs in that one basket,” he says. “Rather than putting $1 million-$2 million into a single asset, you could potentially put it in 15 to 20 assets.”
O’Neill says that via funds, investors can also access more expensive assets than they may be able to afford to invest in directly, with a wider range of tenants, which also serves to reduce risk.
But one of the downsides of investing in commercial property through a fund is a reduction in net yield due to fees. “There’s more risk if you do it yourself, but higher upside, and you’ll make greater profits when it goes well,” O’Neill says.
Collins says management fees vary from 0.5 per cent to 0.8 per cent, with passive funds charging less than actively managed ones. “A good fund manager should be adding far more in value than the fees they’re charging and if they’re not, you should move to another fund.”
O’Neill warns investors should also be aware of fees charged on top of ongoing management fees such as acquisition fees, annual fees and disposal fees, as well as funds that take a cut of capital gains when an asset is sold. “I like the right funds, but they are very fee-intensive. That’s why funds are such big businesses. They make good profits and that profit comes from somewhere,” he says.
Another downside to investing in commercial property via a fund is loss of control over decisions such as tenant selection and when the asset is sold. “You’re putting it in the hands of a professional and for some people, that’s what they want but if you go it alone, you’re going to get complete control over that asset, so you can make the decision as when to sell,” Collins says.
Top picks in commercial property
- O’Neill says industrial property is his top pick in the commercial space, as the take-up of online shopping continues to fuel demand for storage warehouses and logistics centres. He says these assets continue to experience strong rental growth coupled with low vacancy rates.
- When it comes to retail real estate, he prefers supermarkets or small shopping centres to high street-style retail sites. Having multiple tenants is a good way to offset risk, but O’Neill says tenancy mix is key, with an anchor tenant like a supermarket alongside a service-based business such as a medical or childcare centre ideal.
- Office is the one class of commercial property that has been struggling, with CBD office buildings hard hit by firms downsizing their requirements on the back of the shift to working from home. But O’Neill says suburban or city fringe office properties with an accountancy firm, law firm or medical centre as an anchor tenant can still produce strong returns.