Recently we have been asked by some clients that whether investing in commercial property is a good idea. The new policies announced by the government and banks are not in favour of residential property investors, such as the bright-line rule, interest deductibility rule, and the LVR rule. It tends to make the commercial sector more attractive because they are exempt from these rules, and also, the residential properties are getting much more expensive than before. So, if you have a limited budget, investing in commercial properties might be a good choice.

That's why in this video, we are going to talk about the benefits and downsides of commercial property so that we can help you make an informed decision.

 Is it a good time to buy commercial property? 

Video Timeline

1. The benefits of commercial property 02:02

2. The downsides of commercial property 09:29

1. The benefits of commercial property 

(1) Higher ROI

Compared to residential properties, commercial properties generally provide investors with a higher return on their investment. For instance, the average return on investment (ROI) for commercial properties is at least 5-6%, whereas the ROI for residential properties is 3% on average in Auckland.

(2) Fewer ongoing expenses

The commercial property tenants often cover expenses such as property maintenance, building rates, water fixed charge and power bills. This means fewer ongoing expenses for the commercial investors, which is good for your cash flow. However, these costs we just mentioned are often covered by residential property landlords.

(3) Depreciation can be claimed

You can claim depreciation against the commercial building, which is not applicable to residential property, so it helps with tax efficiency.

(4) Diversification of your investment portfolio.

If you already have a portfolio of residential investment properties, then having a commercial property will help you balance your asset types and minimise the risk in investing.

(5) Fewer deposits required

When you purchase a residential investment property, you will need a 40 per cent deposit, whereas this ratio was only 20 per cent during last year. With commercial investment property, you can provide 35% as a minimum deposit. Sometimes you do need to provide more than that, but 35% is definitely possible. So it requires less deposit than the residential property.

(6) Exempt from the new housing policies

The government announced new housing policies regarding the bright-line rule and interest deduction early this year, and commercial properties are exempt from these rules. Therefore for commercial property, you can still claim the interest as part of your investment costs so that you don't have to pay the same level of tax as a residential property. Same with the bright-line rule, there's no bright-line rule that applies to a commercial property.

(7) Flexible budget

In Auckland for example, if you're looking to buy a residential property as an investment, you probably have to expect over $1 million of budget, especially for a property with a reasonable land size, it can easily cost you over $1.5 million. However, it's still possible to find a quality commercial property under $1 million.

Recently, we had a client who bought a warehouse in south Auckland with significant demand, and that only cost $600K. Due to the massive demand for that warehouse, it's possible to see great capital growth in the future. So it's actually a good deal if you have a limited budget.

(8) Have different property cycle from residential property

Typically residential properties and commercial properties are different in the property cycle. When the residential property is in the boom stage, commercial property tends to be flat. In contrast, when the residential property is in a flat market, the commercial property build equity fast. With that said, if you could have a portfolio with a mix of residential and commercial property, you can expect to see consistent capital growth.

(9) More servicing ability

You probably have reached a glass ceiling at some stage and couldn't borrow more if you buy a residential investment property. However, with the commercial property, even you have borrowed to the maximum, potentially you can borrow more to buy a commercial property because the way banks analyse your borrowing capacity in terms of commercial investments is quite different from a residential one. As long as you can demonstrate you can cover the existing residential property loan payments with your existing income, commercial property lending is mainly driven by the commercial rental income. So you may be able to buy another property and add it to your property portfolio.

(10) For owner-occupied: save costs

Let's say you have a business, and you need an office or a factory for your own business, then you can consider buying an existing commercial property and using it yourself rather than renting another workplace. There are some additional benefits if you are owner-occupied:

Firstly, if you need a purpose built property for your business (e.g., daycare, motel, swimming school, petrol station), instead of finding a property with swimming lanes, for instance, you can choose to have your own and build the swimming lanes. So, it would be better to have your own build for a specific purpose rather than doing it for your landlord.

The second benefit is preventing you from paying increased rent over time because that's your own property you don't have to raise rents every year or two if you rent it. But bear in mind there's an opportunity cost involved as well. Let's say you have the option of buying commercial property for your own business, and you also can invest your money into a residential property or other forms of investments. Then there will be an opportunity cost if you rent the commercial property instead of purchasing, you may be able to get better capital growth if you invest in other types of assets. So you have to consider the overall picture, not just from the rent perspective.

The above are the benefits of buying a commercial property from both investment and owner-occupied aspects.

On the surface, commercial property investment can seem like a great idea. However, if two sides of the same blade are sharp, it cuts both ways. So, if you are thinking about investing in a commercial building, you should not only consider the benefits but also ensure that you are aware of the potential downsides as follows:

2. The downsides of commercial property

(1) Vacancies

The vacancies for residential property are relatively low. Even in the situation that your tenants only give you a short period of notice, you can still get new tenants within a couple of weeks due to the strong demand in the market. So the vacancy is low compared to a commercial property.

Take the building we occupied now as an example: some offices have been keeping empty for over a year. This phenomenon has worsened after COVID because many people work from home, so the demand for offices is much less than before.

However, that's not always the case. An experienced commercial property expert told us that many people used to work in the CBD, but now they're looking for offices in the region, which causes a good demand for some areas like North Shore.

Given that overall offices are in less demand after COVID, you need to be aware, especially if you buy a vacant commercial property or even you have existing tenants there but the lease is very short (a year or two), then what if they decide not to renew? How long can you replace them?

(2) Limited capital growth

Generally speaking, the capital growth for a commercial property is mainly driven by the lease income, therefore the grow rate is generally less than residential properties. In other words, if you don't have tenants or the lease income is not increased quickly, then the capital growth will be very limited. But it's not always the case at the moment. For example, industrial properties are currently in demand, no matter it is vacant or not, it still grows value at a speedy pace.

(3) Lack of knowledge and experience

One of the most significant risks of investing in commercial buildings can be the insufficient experience. Commercial property investment requires different skill sets and knowledge from investing in residential properties. If you are going to purchase your first commercial property, you need to do some homework and build your knowledge base before going ahead.

(4) The risk of having to pay off the loan when the loan term ends

If you already settled a commercial property and you have a loan against that, bear in mind that when your tenants leaving, you need to quickly replace them especially if you only have one tenant. This is because when the bank lends you the money for buying a commercial property, the loan term is normally aligned with your lease remaining term. For example, suppose you have one tenant and the lease term is three years, even though they already approved you with a 15-year amortisation repayment. In that case, the loan term is only going to be three years because they want to review your position and see how the lease is going to be after three years – will your tenants renew the lease, or will you be able to replace them very soon? They want to know this because the lease income is your primary repayment source. If you don't have a lease in place, then it means you can't repay from the bank's eyes. That's why your bank often limits the loan term to the lease remaining term.

We have a real-case example where the clients had tenants at the time of placing the commercial loan, but then the tenants left. When the bank reviewed their tenant's schedule, they realized that there's no tenant anymore. The clients were comfortable because they had a good cash flow from other sources (other properties and job income), but banks only allowed for a couple of months to find new tenants, otherwise, the client have to repay the loan, which put them into a stressful stage.

Therefore, bear in mind that banks mainly consider the lease income for a commercial loan. If you don't have lease income, you risk repaying the loan with such short notice. Whereas for a residential investment property loan, banks typically allow for the repayment period of 25-30 years, and they won't come back and check if you have tenants or not.

The above is almost everything we could think of for the benefits and the downsides of buying a commercial property from both investment and owner-occupied perspectives. Any questions? Or seek help? Call us at 09 930 8999 to have a no-obligation chat with one of the financial advisors at Prosperity Finance.

Read more:

Is commercial property now a more attractive investment than residential property?

Are higher interest rates coming?

Should you be concerned about DTI (debt-to-income ratio)?

Disclaimer: The content in this article are provided for general situation purpose only. To the extent that any such information, opinions, views and recommendations constitute advice, they do not take into account any person’s particular financial situation or goals and, accordingly, do not constitute personalised financial advice. We therefore recommend that you seek advice from your adviser before taking any action.