Investing in Commercial Property: Part 1

I believe that most people would be well-served by investing in various asset classes, including shares and property. I do not believe that any one asset class is superior. They all have their pros and cons which you can balance out in a diversified investment portfolio, which could include commercial property.

Commercial property does have some wonderfully attractive attributes but it’s important to introduce it into your portfolio at the right time (stage of life) and of course, invest in the right asset using the right methodology.

I will explain this in a two-part blog. This first part will provide an introduction to commercial property. The second part will consider how to successfully invest in this asset class.

Attraction to commercial property

Most investors are very familiar with residential property as an investment option. As I have highlighted in this blog many times, residential property is a growth asset because it provides most of its total return in the form of capital growth and proportionately very little income.

One of the main attractions to commercial property is that it typically provides a higher level of income, which may be particularly attractive if you are close to retirement, or you already own a few residential investment properties.

Types of commercial property

Commercial properties can have a varying array of attributes and no two properties are likely to be identical. That said, there are three broad categories of commercial property:

  • Office: An office building is usually a multi-level building that has multiple tenants. These buildings are typically situated in central, well-established locations (CBD or suburban hubs), which adds to their scarcity and tends to drive capital growth.
  • Retail: this includes retail shops in suburban shopping strips, mixed-use premises, and specialised properties such as service stations and restaurants. Because these assets are typically located in high-demand locations, they tend to generate lower rental yields. 
  • Industrial: this includes industrial sheds, bulky goods centres (bunnings) and the so on. These assets tend to be located in outer, fringe locations and as such may offer higher rental yields.

How does commercial differ from residential?  

Given most people have an understanding of residential property attributes, I thought the best way to introduce commercial property is through making a comparison with residential property.

Rental yield

With regard to rental income, there are two main differences between commercial and residential property.

Firstly, a commercial tenant pays for most of a property’s expenses including rates, insurances, maintenance and so forth. The only exception to this may be land tax. In Victoria, if the lease is covered by the Retail Leases Act 2003, the landlord cannot on-charge the cost of land tax to the tenant. However, as property is regulated by the states, rules may vary from state to state. Suffice to say that given a commercial tenant pays for almost all expenses, it means these investments tend to generate a lot more income than residential properties.

Secondly, rental yields tend to be higher than residential, especially for office and industrial properties. Office rental yields tend to range from 4% to 6% p.a. Industrial rental yields can range from 4% to 9% p.a. This compares favourably to residential houses which typically yield circa 2% p.a. gross (in Melbourne and Sydney), which might be reduced to just over 1% p.a. after all expenses (of course, well-located residential houses more than make up for this with capital growth).

What drives commercial property values?

Investment-grade residential property values are driven by the underlying land value. When demand exceeds supply, the value of the land will appreciate. That is why well-established, blue-chip suburbs are attractive to invest in. 

However, the value of a commercial property is almost always driven by its rental income stream. Investors will apply a capitalisation rate to the property’s income stream to determine its value. A capitalisation rate reflects the investors desired rate of return.

For example, if a commercial property generates $100,000 of annual rental income and if the investor desires an investment return of 5% p.a., then this investor would be willing to pay up to $2 million for this property (divide annual income by capitalisation rate).

An investor would consider many things when determining a capitalisation rate including the financial strength of the tenant (e.g. government tenants tend to be lowest risk) and the strength and length of the existing lease over the premises. Longer leases are typically more attractive to investors if they are on attractive terms, of course. If the building has multiple tenants, investors use WALE as a measure of the strength of the building’s income stream. The cost of capital (i.e. interest rates) also influences capitalisation rates. The less risky a building’s income stream is considered, the lower the capitalisation rate.

Sometimes investors will be prepared to buy a commercial building on a low capitalisation rate if they expect the property to appreciate in value (i.e. capital growth). This was the case 20 years ago in Melbourne when retail shops on Chapel Street (South Yarra) were selling on yields of only 1-2%. Suffice to say that approach hasn’t turn out well for investors!

Lower LVR’s

Most banks will lend residential property investors up to 90-95% of a property’s value. That means an investor only needs to contribute 5-10% plus costs (stamp duty).

However, for commercial properties, maximum loan to value ratios (LVR) tend to be restricted to 65-70% (sometimes 80% but that usually attracts materially higher interest rates). This means investors need to have more cash or equity in existing property to be able to invest in commercial property.

A decade ago, commercial interest rates used to be much higher than residential mortgage rates. However, today, interest rates for commercial and residential property are often materially the same. 


Residential property almost always does not attract any GST consequences, unlike commercial property.

Sometimes GST is payable on the purchase price of a commercial property, especially if there is no pre-existing lease. If there is a pre-existing lease/tenant in place, then the sale will typically be treated as a going concern and GST will not be added to the purchase price. Purchasers should clarify this and ensure the purchasing entity (e.g. company or trust) is registered for GST, just in case, so they can claim a GST refund if necessary.

Commercial rent usually attracts GST. That means you will need to charge the tenant GST and lodge a quarterly (maybe annual) Business Activity Statement (BAS) with the ATO.

When can commercial property provide capital growth?

It is possible to enjoy capital growth as well as income from a commercial property. This tends to occur in two circumstances:

  1. The property is located in a highly desirable location or is available for an alternative use. For example, a property located in a previously industrialised location that is becoming gentrified and could be converted/developed into a residential building (e.g. Collingwood in Melbourne).
  2. The investor improves the property’s rental income stream. That could include replacing ‘risky’ tenants with safer tenants, increasing the lease term or WALE, making improvements to the property to increase the rental amount (e.g. for office buildings that can include refurbishing the foyer/atrium, providing end-of-trip facilities, pre-fitted offices, refurbishing the lifts and so on).  

Commercial property investors should not expect to enjoy a high level of capital growth and a high rental yield (income) perpetually. Typically, the market will correct, and high growth commercial properties will tend to generate very low rental yields. Your total (income + growth) long-term return typically will not materially exceed 10% p.a.

When is it appropriate to invest in commercial property?

It is usually not appropriate for clients to invest in commercial property until they have established a sound investment asset base in less risky assets such as shares and residential property. There are three predominant reasons for this:

  1. As stated above, investing in commercial property requires you to have substantial equity in existing (residential) property or a large cash deposit, so you need to have a strong asset base to begin;
  2. Commercial property is a higher risk investment compared to residential because it is impacted by the vagaries of the prevailing economic climate. This can include periods of lower/no income and/or volatility in values. However, since residential property is a necessity (we all need somewhere to live), it tends to be less volatile and the best asset class to begin with; and
  3. There are some excellent commercial property investment options (which I’ll discuss next week), but they tend to be restricted to wholesale investors only.

Next week: Commercial property investment options

In the second part of this blog (out next week), I will discuss your options for successfully investing in commercial property.