A majority of my clients are comfortable with investing in residential property, because most have rented or bought for their own use. And therefore understand what that experience entails. However, very few have actually had similar experiences with commercial property and are, therefore, a little less confident in investing in this potentially lucrative segment.
Commercial property can add diversification to a portfolio. Segments within the real estate market rarely move in tandem and a mixture of residential and commercial can make an overall portfolio more resilient to inevitable market cycles.
Risk and reward
All things being equal, commercial generate an RoI (return on investment) at least double that of residential. This is mainly due to lower per square foot capital cost, but also reflects the higher levels of risk associated with owning commercial property.
Managing tenants in a commercial property is also more straightforward. You will have a business-to-business relationships with tenants, and many of the emotional issues that can complicate residential leasing arrangements won’t exist. It’s easier to keep interactions professional and focused, and fruitful relationships can be built over time to attract blue-chip tenants.
They are likely to rent your property for a longer period and less likely to default on payments. In many cases, commercial tenants and property owner interests are aligned. The tenant wants an efficient operation that presents a favorable impression to his customers, business associates or peers and, in this way, is more likely to assist the owner maintain or even improve the property.
Establishing a true value of the investment is often easier with commercial. Reviewing the current owners’ income statement and existing lease details will provide a good indication of likely cashflows and help establish an accurate valuation. Residential properties are often subject to more emotional pricing, developer inefficiency and cost recovery considerations.
Many sides to a lease
Lease variations abound for commercial properties. The requirements of a tenant operating a high turnover regional distribution and logistics center for non-perishable goods will be vastly different of those of a tenant who requires refrigerated goods storage to supply local retail outlets. In addition to lease rates, negotiations can include such items as maintenance, implementation of storage and logistical systems, provision of office fitouts, insurance, lease-to-buy options… the list goes on.
However, there are some possible downsides the investor should consider.
Let’s use a warehouse as an example. As most commercial leases are of a duration exceeding two years, with many being of five years with options for an additional five, it could take some time to find a new tenant. Additionally, your current tenant may vacate due to tough economic conditions. Residential property can be resilient when it comes to economic factors over the long term and finding new tenants is not as difficult.
As the lease for each commercial facility can be negotiated with flexibility only limited by law, owning a portfolio with numerous commercial properties can be time consuming and complicated. You will need professional help just to handle issues such as maintenance and sundry emergencies.
Remember, your clients will be relying on you to address any issues that arise with your property immediately. They, like you, do not want to forgo any revenues or incur costs because of a problem with the property or premises that you provide.
Purchasing a commercial property of a size that can generate significant cashflow will typically require more capital upfront than a residential investment. Also, as the scale or size of the premises can be huge, unexpected repairs or major maintenance items can be expensive. This requires careful provisioning when calculating lease rates and free cashflows for re-investment.
There is a greater array of physical and safety risks associated with commercial properties. Warehouses, for example, are often frequented by trucks, forklifts or other heavy machinery, which means damage can be substantial from accidents. Having proper insurance is a must, not only for damage to premises and systems, but also in the event of personal injury or death where you, as the owner, can be held liable.
Remember, your investment is actually operating as a commercial venture and can receive high volumes of people traffic.
As usual, greater returns will attract greater risks. However, as part of an overall balanced investment portfolio, there is no doubt that commercial space can be very lucrative indeed.
- Mohanad Alwadiya is CEO of Harbor Real Estate and senior instructor at Dubai Real Estate Institute.