Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 26

Investing in commercial property

Approximately ten years ago, I became involved in the small commercial property market as an investor. My research had shown this was an investment segment that provided steady income growth and capital gains when you take a longer-term investment approach (10 years+). I have since added more commercial properties to my portfolio and the experience to date has been favourable.

This article provides some insight into the investment opportunities and risks in the smaller end of the commercial market (valued at around $2 million or less) and why it is different from residential. These small commercial properties are sometimes purpose-built for tenants who are expanding or updating, and they can have a mixture of commercial and industrial uses.

Variable returns from prime properties

Commercial property has a similarity to fixed interest investing in that valuations are based on yield expectations. The most common proxy for valuations of smaller properties is the capitalisation method (‘cap rate’), where the net income is divided by the market value or purchase cost.

Cap rates for good quality, prime properties are around 7% – 8% currently, although each building is unique and returns vary significantly. Competition for the best locations can drive yields lower. Some examples of recently reported sales include:

  • Commonwealth Bank Lilydale, sold for $2.88 million at 4.5% yield
  • Bank of Queensland Varsity Lakes, sold for $620,000 at 7.5% yield
  • Red Rooster Toowoomba, sold for $1.88 million at 7.2% yield
  • VicRoads Regional Victoria, sold for $920,000 at 5.5% yield.

It is possible to obtain funding at around 5.25% – 5.5%. This means you can buy high quality-tenanted properties that are cash flow positive day one i.e. positive gearing.

Consider the following example:

  • the property is valued at $1 million
  • acquisition costs are 5%
  • 100% of the purchase price is borrowed at 6.5%
  • rental is $80,000 pa and increases are 3% pa
  • capital growth (increase in value of property) is 3% pa
  • the capitalisation rate is 7.62% ($80,000/$1.05 million).

The graph shows that after 10 years the total ‘profit’, ignoring tax effects, is $500,000, made up of $235,000 surplus cash and $265,000 increase in property value. I don’t recommend 100% gearing unless you have other equity you can risk. There is, of course, nothing profound in these numbers, since the example assumes the property is positively geared and increases in value each year. But this has been my past experience and many investors who only consider the residential market are missing the potential of commercial property.

Important risks to understand

As with all investments, commercial property has risks and you need to build some contingencies into your budgeting for when this will happen. The main one in my view is ‘tenant risk’, where the property may be vacant for 6-12 months. It is common to obtain a bank guarantee for the first 3-6 months rent as part of an acquisition.

My experience is that valuers don’t tend to take into account to a significant extent the value of the tenant when determining the market value of a small commercial property. They will make reference to the tenant in their report but don’t qualify the value based on the tenant bonafides. I would rather take a marginally lower rent and wait an extra 3-4 months to get the right tenant, than take on a potential tenant who may encounter cash flow problems in the future. Again, you need to do your research. I have seen market reports on commercial properties which state that the average yield on national tenants is about 1% less than non-national tenants, but this has not been my experience.

Leases are typically in the 3-5 year range and the tenant pays for most of the maintenance costs. e.g. strata levies, rates and water. Get the right lawyer to draw up the lease and the tenant can even pay your land tax.

I prefer better quality properties with excellent tenants (e.g. national brand names and subsidiaries of public companies) on longer leases (5 years) in the 500-700 square metres range, in growing areas with excellent transport links.

To get the best interest rate when borrowing, banks don’t like the loan to valuation ratios (LVRs) to exceed 65% and will charge a higher interest rate for the higher risk. To be conservative I’d suggest a 50/50 gearing ratio as during the GFC, banks wound back their LVRs and clients that didn’t have spare cash ended up selling at fire-sale prices.

As in the share market, investors have been chasing yields in the last year, and this has increased commercial property prices, notwithstanding that real estate agent Knight Frank recently reported a high commercial property vacancy rate of 10.1%. The increased borrowing appetite of SMSFs is another competitive factor.

Furthermore, there are signs of weakening fundamentals such as loss of manufacturing jobs, small business stress, other staff reductions and falling rents which add a further need for caution. The specific supply and demand characteristics of the location are affected by the local economy, industry mix, transport patterns, planning permissions, capital expenditure and potential secondary use on sale.

It emphasises you need to do your research, which means reading, inspecting premises, speaking to agents and bankers. That way you will start to develop an understanding of the issues involved when you see the right commercial property, and you will have a better chance of making an informed decision.

 

Jack McCartney has worked in a variety of senior management roles in financial services and most recently ran Commonwealth Bank’s Business Bank Wealth division.

 


 

Leave a Comment:

RELATED ARTICLES

Has Australian commercial property bottomed?

Three opportunities in property in Australia and APAC

Five megatrends driving the Liquorice Allsorts of real estate

banner

Most viewed in recent weeks

16 ASX stocks to buy and hold forever, updated

This time last year, I highlighted 16 ASX stocks that investors could own indefinitely. One year on, I look at whether there should be any changes to the list of stocks as well as which companies are worth buying now. 

UniSuper’s boss flags a potential correction ahead

The CIO of Australia’s fourth largest super fund by assets, John Pearce, suggests the odds favour a flat year for markets, with the possibility of a correction of 10% or more. However, he’ll use any dip as a buying opportunity.

2025-26 super thresholds – key changes and implications

The ABS recently released figures which are used to determine key superannuation rates and thresholds that will apply from 1 July 2025. This outlines the rates and thresholds that are changing and those that aren’t.  

Is Gen X ready for retirement?

With the arrival of the new year, the first members of ‘Generation X’ turned 60, marking the start of the MTV generation’s collective journey towards retirement. Are Gen Xers and our retirement system ready for the transition?

Why the $5.4 trillion wealth transfer is a generational tragedy

The intergenerational wealth transfer, largely driven by a housing boom, exacerbates economic inequality, stifles productivity, and impedes social mobility. Solutions lie in addressing the housing problem, not taxing wealth.

What Warren Buffett isn’t saying speaks volumes

Warren Buffett's annual shareholder letter has been fixture for avid investors for decades. In his latest letter, Buffett is reticent on many key topics, but his actions rather than words are sending clear signals to investors.

Latest Updates

Investing

Designing a life, with money to spare

Are you living your life by default or by design? It strikes me that many people are doing the former and living according to others’ expectations of them, leading to poor choices including with their finances.

Investment strategies

A closer look at defensive assets for turbulent times

After the recent market slump, it's a good time to brush up on the defensive asset classes – what they are, why hold them, and how they can both deliver on your goals and increase the reliability of your desired outcomes.

Financial planning

Are lifetime income streams the answer or just the easy way out?

Lately, there's been a push by Government for lifetime income streams as a solution to retirement income challenges. We run the numbers on these products to see whether they deliver on what they promise.

Shares

Is it time to buy the Big Four banks?

The stellar run of the major ASX banks last year left many investors scratching their heads. After a recent share price pullback, has value emerged in these banks, or is it best to steer clear of them?

Investment strategies

The useful role that subordinated debt can play in your portfolio

If you’re struggling to replace the hybrid exposure in your portfolio, you’re not alone. Subordinated debt is an option, and here is a guide on what it is and how it can fit into your investment mix.

Shares

Europe is back and small caps there offer significant opportunities

Trump’s moves on tariffs, defence, and Ukraine, have awoken European Governments after a decade of lethargy. European small cap manager, Alantra Asset Management, says it could herald a new era for the continent.

Shares

Lessons from the rise and fall of founder-led companies

Founder-led companies often attract investors due to leaders' personal stakes and long-term vision. But founder presence alone does not guarantee success, and the challenge is to identify which ones will succeed in the long term.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.