Investing in commercial property can be very rewarding and for many, a good way to diversify from their residential property investments. There is an opportunity to achieve strong net yields, along with capital growth. However, buying and evaluating commercial property comes with an extra set of challenges and can be tricky for the unwary.

The true net return:
Unlike residential property where the tenant pays you rent (gross rent) and you pay all the outgoings; with commercial property the tenant often pays you rent (net rent) and they also pay the outgoings in addition. When considering purchasing a commercial property, do your due diligence as often the reported net returns or net yield that is advertised is not the true net yield.

Often a tenant won’t pay for; the additional Land Tax payable if you purchase in a trust or pay your property managements fees over a certain amount, if at all.

Lease rates:
At your first market rent review you want your rent to increase not decrease. When you are evaluating your purchase it is critical to ensure that the rental rate your tenant is paying is consistent with the rental rates of similar properties or “is at market rates”.

Outgoings:
Likewise with the outgoings of the property, it is important that they are benchmarked against similar properties. Low outgoings may mean that the building is not being properly maintained which can cause problems in the future. And high outgoings might present an opportunity to reduce them in the future thereby increasing your return.

CASE STUDY
A commercial property is advertised for $1.6m with a reported net yield of 8.2%. The rent is $438 per sqm x 300 sqm of area = $131,400 p.a. (plus outgoings payable of $75 per sqm or $22,500 p.a.).

The outgoings specified in the lease do not include; land tax if owned by a trust or property management fees and there is no ratchet clause in the lease (a clause which prevents the rent from decreasing at market reviews). After some investigation you discover that comparable rent rates are $410 per sqm (plus outgoings). And also the outgoings for similar properties are more like $90 per sqm not $75 per sqm as reported on this property.

The real return on this property:
The tenant will cover land tax to $3,684 however; as you purchased in a trust, it is $9,600.00 (based on a UCV of $600,000). So in this case, you pay the difference of $5,916 p.a. You will also pay property management fees of $6,156 p.a as these are not paid by the tenant.

So now your “unrecoverable” outgoings are $5,916 + $6,156 = $12,072.

Further, at the next market review  your rent could decrease from a rate of $438 per sqm to the correct market rate $410 per sqm or $28 per sqm x 300 sqm = $8,400 p.a.
The net yield is now $131,400 - $12,072 - $8,400 ÷ $1.6m = 6.93%.

In conclusion, your true net return could be less than initially advertised and in this case the outgoings are also below market rates which may mean that the building is not being maintained appropriately. These are only a couple of the issues that you will often encounter.

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