Commercial property for residential investors

You know residential cold. Commercial is a foreign country. This chapter is the phrasebook.

If you have bought, sold or even seriously researched residential property, you carry a full set of instincts. You know what a good suburb feels like. You can smell an overpriced listing. You know roughly what rent a three bedroom house pulls and what happens at an auction when two emotional bidders want the same kitchen.

Here is the uncomfortable news: in commercial property, most of those instincts misfire. Not because commercial is harder, but because it runs on a different engine. Residential is priced on emotion and scarcity. Commercial is priced on income and risk.

The good news is that the translation is learnable, and once it clicks, commercial is in many ways more honest. Nobody falls in love with a warehouse. The numbers either work or they do not.

This chapter maps every major residential concept to its commercial counterpart. Read it twice. Everything in the rest of part three stands on it.

Translation one: from rental yield to capitalisation rate

In residential, yield is a by-product. You buy the house, the market sets the rent, and the yield is whatever falls out of the division.

In commercial, it runs the other way. Income determines value. The market applies a capitalisation rate, a cap rate, to the property’s net income to decide what the building is worth.

The formula is one line: value equals net annual income divided by the cap rate.

A warehouse earning $42,000 net, in a market where buyers demand a 6 per cent return for that type of asset, is worth $42,000 divided by 0.06, which is $700,000. That is not a rule of thumb. That is substantially how the valuer will do it.

Two consequences follow, and they will bend your brain the first time.

First, income changes move value directly. Lift that warehouse’s rent to $46,000 at the next review and, at the same 6 per cent cap rate, the property is now worth about $766,000. A $4,000 rent rise created $66,000 of value. In residential, a rent rise makes your spreadsheet happier. In commercial, it makes you richer on paper the same day.

Second, cap rates move value inversely, and brutally. If market sentiment shifts and buyers demand 7 per cent instead of 6 for that asset class, your $42,000 income is suddenly worth $600,000. Nothing happened to the building. The market just repriced the risk. Cap rates drift with interest rates, tenant demand and fashion, and a 1 per cent move swings values by double digit percentages.

So when you look at a commercial listing, train yourself to see two numbers where a residential buyer sees one: what is the net income, and what cap rate does this asking price imply? If a $700,000 listing earns $35,000 net, the vendor is asking you to accept 5 per cent. Your whole job as a buyer is deciding whether that particular income stream deserves 5 per cent, or whether it is really a 6.5 per cent risk wearing a 5 per cent price tag.

Translation two: from tenancy agreement to commercial lease

A residential tenancy agreement is a standard form wrapped in consumer protection law. Terms are short, rights are legislated, and one tenant is much like the next.

A commercial lease is a negotiated commercial contract, often 40 to 100 pages, and it is the single most important document in this entire field. Say it with me: the lease is the asset. When you buy a tenanted commercial property, you are not really buying bricks. You are buying a contract that obliges a business to pay you money for years, with the bricks as the delivery mechanism.

The same building with a different lease is a different investment at a different price. A shop with a national brand on a fresh ten year lease and a shop with a struggling sole trader on six months remaining might be physically identical and differ in value by 30 per cent.

What lives inside the lease, and has no residential equivalent:

Term and options. Commercial leases run three, five, ten years, with options for the tenant to renew. A “5 plus 5” means five years certain, then the tenant’s choice of five more. Long terms are security; they are also handcuffs if the rent was set badly.

Rent reviews. The lease itself dictates how rent changes: fixed increases (say 3 per cent a year), CPI linked, or market reviews at set dates. Read this clause before anything else. It is the growth engine of your income, pre-programmed years in advance.

Permitted use. The lease defines what business can be run there. Narrow use clauses limit your pool of replacement tenants.

Make-good. The tenant’s obligation to return the premises to original condition when leaving. Well drafted, it saves you a refit. Poorly drafted, you inherit someone’s abandoned fitout.

Assignment and subletting. Whether and how the tenant can hand the lease to someone else. This is how your carefully chosen tenant can be replaced without your enthusiasm.

One more thing. Retail premises are the exception to the freedom of contract story: every state has retail leasing legislation that imposes minimum standards, disclosure obligations and, in several states, minimum five year terms. If you buy a shop, that legislation shapes your lease whether you like it or not. Chapter 7 flags the state quirks that matter, including a Victorian land tax rule that costs retail landlords real money.

Translation three: from landlord pays to tenant pays

In residential, you collect the rent and pay everything else: rates, insurance, water, maintenance, land tax. Your gross yield shrinks by a quarter to a third on its way to becoming net.

Commercial flips it. Under a net lease, the standard for most freestanding commercial property, the tenant pays outgoings on top of rent: council rates, building insurance, water, often land tax, sometimes management fees. That is why commercial yields are quoted net and residential yields gross, and why a 6 per cent commercial yield and a 4 per cent residential yield are even further apart than they look.

Under a gross lease, more common in offices and some retail, the rent is a single all inclusive number and the landlord pays outgoings from it. Neither is better; they are just different ways of slicing the same pie. What matters is that you read which one you are buying, and that the outgoings are properly estimated, billed and reconciled each year. Chapter 9 covers the mechanics.

The sting in the tail, worth repeating from chapter 5: outgoings follow occupancy. The day the tenant leaves, rates, insurance and land tax swing back onto you, at the exact moment the rent stops. A vacant commercial property is not a paused investment. It is a running cost.

Translation four: from comparable sales to income evidence

When a residential valuer values a house, they find three similar recent sales and adjust. When a commercial valuer values a warehouse, they primarily capitalise the income, cross checked against sales of comparable income streams and a rate per square metre.

For you as a buyer, this changes what “doing your research” means. Residential research is sales histories and suburb medians. Commercial research is rental evidence: what are similar premises leasing for per square metre, what cap rates have similar assets sold on, and what incentives are being paid in this market right now?

Which brings us to the concept that catches every residential investor at least once.

Incentives: the discount nobody advertises

In commercial markets, especially office and retail, landlords compete for tenants by offering incentives: rent free periods, fitout contributions, reduced rent early in the term. Incentives of 10 to 30 per cent of total lease value are common in soft markets, and they do not appear in the headline rent.

That creates two rents for the same lease. The face rent is the number written in the lease and quoted in marketing. The effective rent is what the tenant actually pays once you smear the incentive across the term. A “$50,000 a year” lease with a year rent free on a five year term is really a $40,000 a year lease wearing makeup.

Why does everyone play along? Because face rents feed valuations and rent review comparisons. As a buyer, your defence is one question, asked every time: what incentives were provided on this lease and on the comparable evidence? If the agent gets vague, assume the answer is “large”.

The two numbers that measure safety: WALE and covenant

Residential income safety is simple: if this tenant leaves, another arrives in a few weeks at much the same rent. Commercial income safety has to be measured, and the market uses two gauges.

WALE, the weighted average lease expiry: , tells you how many years of contracted income remain, weighted by rent. A property with one tenant and seven years to run has a WALE of seven. A property with three tenants on staggered short leases might have a WALE of 1.8. Longer WALE, safer income, higher price, lower yield. Shorter WALE, cheaper price, and a re-leasing problem with your name on it.

Tenant covenant: is the quality of the promise behind the lease. A ten year lease is only as good as the business signing it. A national retailer, a government agency or an ASX listed logistics firm is a strong covenant. A first year café is a weak one, whatever the lease says. Covenant is why two identical buildings with identical rents can trade at different cap rates: the market pays up for promises it believes.

When you assess any commercial property, write these two down before you fall for the building: WALE in years, covenant in plain words. “Four years, established national franchisee” is a different investment from “eleven months, local startup”, even at the same price.

Vacancy: the risk you are being paid for

Last translation, and the one to tattoo somewhere visible.

Residential vacancy is a few weeks between tenants, a couple of times a decade. Commercial vacancy is six to twelve months as a normal case, and multi year for the wrong property in the wrong market. Finding a commercial tenant means finding a specific kind of business, at a specific scale, ready to commit years, possibly needing a fitout, often demanding an incentive.

This is the risk the higher yield is paying you to hold, and it is why chapter 5’s stress test uses twelve months, and why the cash buffer is not optional. It is also why everything else in this chapter matters: a strong covenant, a long WALE, a sensible use clause and honest effective rents are all, in the end, vacancy insurance.

Residential pays less because its income barely pauses. Commercial pays more because its income can stop dead. Neither is better. But only one of them is now available to your fund with borrowed money, so you had better be fluent in it.

Find your sweet spot, or have the guts to walk away.