As a person who has invested heavily in residential and commercial properties, I have seen both sides of the fence when it comes to investment strategies.
After many years in the industry, I have come to the conclusion that any investor planning to retire using rental property income should seriously consider having a commercial property in their portfolio .
Residential property can build a solid foundation on which to build, but the fact is that yields on residential properties are far too low for many people to retire. In my opinion, the quickest way to generate viable passive income for retirement is through commercial real estate, which is why I personally made the choice to invest. in this asset class, and since that day, I have been addicted to business investment.
Let's explore some of the reasons why residential property may not be the ideal investment to support you adequately in retirement.
The traditional way of success in real estate investment
To generate a reliable income from residential property, the most effective strategy is to have very low debt levels, as well as a very large asset base. Even then, vacancies and unexpected maintenance issues can tear up your cash flow returns – so it's critical that you put a buffer in place to deal with them.
Many experts in residential real estate will recommend buying multiple residential properties, keeping them for a few decades and waiting for rental income to increase, while reducing debt at the same time.
The idea is that after two decades the mortgage should be fully repaid – with the help of your tenants – allowing you to profit from the profitability of rent as income.
For me, this process was just too slow. I was able to quit my day job at the age of 28 using a much more aggressive strategy, which was to take advantage of business investments and take advantage of their high returns.
The other major flaw in this long-term residential ownership strategy is that, even when your residential property is debt-free, the returns are too low compared to those of other classes of property. assets, hence an inefficient use of your capital
There are many possibilities to buy commercial property at a lower price and with a good quality tenant in place
For example, if you owned three residential properties worth $ 700,000 each, and they were all fully repaid, you would have $ 2.1 million in real estate assets. Sounds good, right? However, with a gross yield of 4%, your income on your debt-free property would only be around $ 60,000 a year once municipal rates and water bills, fees are met. insurance and maintenance were taken into consideration. You will also need to consider the income tax that would be payable on your rental income of $ 60,000.
For a portfolio worth $ 2.1 million without debt, $ 60,000 in gross pre-tax income is not enough, I fear!
Suppose you have instead invested $ 2.1 million in commercial properties offering a net return of 7.5%. With the tenant paying most of the ongoing costs, such as consulting and maintenance rates, this investment would pay you $ 157,500 a year after costs. Of course, income tax is still payable on these profits, but if you compare commercial returns with long-term residential income, there is clearly a winner here. It’s obvious, right?
These are big numbers I'm talking about here, but there are plenty of opportunities to buy commercial property at a lower price and with a good quality tenant in place. People often think that trading is a very expensive asset class that requires millions of dollars to enter, but the reality is that you can find a commercial building in a capital for $ 350,000 – or sometimes even less.
With a good tenant in the property, a longer-term than residential lease and a much better cash flow than residential yields on the current market, investors are increasingly looking for business opportunities. A net return of 7% on a property priced between $ 300,000 and $ 400,000 can generate hundreds of dollars per week in positive cash flow.
A question of capital growth
There is a misconception that you don't get capital growth from commercial properties, but that couldn't be further from the truth. It all depends on supply and demand, with ratios and fundamentals that resemble those of residential investments.
Some of the fastest growing deals I have ever made have been commercial. I myself owned a property in the Newcastle area; it was a small warehouse and, in one year, its value increased by 26%.
It increased as quickly because, in summary, interest rates were falling and I was able to negotiate better rent and a rental lease, which meant that the market was willing to pay more. expensive for the property than what I had paid for.
There are many possibilities to buy commercial property at a lower price and with a good quality tenant in place
During this same period, the value of residential properties has not increased as rapidly. One of the main reasons why people are more comfortable investing in residential real estate, besides the fact that it is familiar to them, is that they believe that the prospects for capital growth will be stronger, but this is not always the case.
Also, do investors really understand what level of growth they can expect over 30 years?
Let us examine the price changes over 30 years in the table below.
As you can see, the average growth in house prices in our capitals is between 5% and 6.1%. This level of growth is not too exciting, given that the past 30 years represent a period that many would say is the greatest period of growth for residential properties that we will ever see.
Understand me well: this is good capital growth. But when most investors rely on negative gearing to maintain their cash flow and make their investments affordable, the result will not send you into early retirement unless you try something different.
Let us now see how commercial properties can tip the chances of early retirement in your favor.
Higher net returns: For commercial real estate, returns can be significantly higher than those for residential real estate. In 2020, at Rethink Investing, we still find quality commercial properties in capitals with net returns of between 6.5% and 8.5%. These are extremely good yields since most of my clients get commercial loans with interest rates starting with a 3.
Solid Debt Reduction Strategy: One of the common strategies of my clients who invest in commercial properties is to use the high net income from the rent of commercial properties to repay the loans over time. This allows the owner of a commercial building to pay off debts up to zero in half the time of a standard 30-year loan agreement – sometimes even sooner.
What many people don't realize is that high-yielding commercial property can pay for itself in 10 to 13 years. This is possible because the high cash flow of the net lease can be very strong, and if you can put the excess rent back into your mortgage or compensation account, the debt will decrease quickly, without you having to make any additional payments.
Let's take a look at the numbers in the example of a commercial property (see table above), which shows what happens when you deposit a positive cash flow in debt.
Here is an example of a property with a net yield of 7.5% and a 3% increase in rent per year. Without the owner having to inject their own funds, the property is fully reimbursed in 12 years.
However, more importantly, this property offers passive income of $ 96,239 with zero debt at year 12. These types of returns can only be obtained from commercial property, and for this reason, it is an extremely important asset class for investors looking to accelerate their path to earlier retirement.
With risk comes the reward
Part of my job is to educate investors about the benefits of putting their money in business assets and reassure them about the risks involved.
As with residential property, finding the right commercial property is the key to success. However, there is much more due diligence required for those who invest in a commercial property compared to a residential property.
In my opinion, most properties advertised on the Internet do not add up once you have done all the due diligence. It takes time, dedication and an experienced operator to choose the right business investments. For example, we review and reject approximately 30 properties for each that we buy on behalf of a client.
When you find the right deal, commercial properties can exceed the best of what you can find in the residential, making it a difficult but exciting asset class to invest in. The numbers speak for themselves, which is why I chose this as my preferred route to go down as an investor.
If you want to invest in commercial property, how do you minimize the risks? Just like you would with a residential property, you should start by doing your research. You need to talk to a lot of experts in the field who have already purchased these types of properties and familiarize yourself with this asset class by calling commercial real estate agents, even if it's just asking them questions about recent sales and the announcements they have coming.
There is not as much data on sales and trends in relation to residential investment, and there are not as many good books to read on the subject. This is why you need to talk to people who have been there and who have done so – preferably for many years and on multiple offers. You want to talk to investors who can tell you both the good and the bad about commercial real estate investing so that you can develop your knowledge and take your time.
Commercial real estate investing offers a number of advantages to the savvy investor, which is why my main advice is simply this: be open to it. It is still as cool, unknown and less spoken as the residential asset class, but it is an important part of the Australian economy. And the more we keep talking about it, the more people will realize that there are high quality deals in every price range, in every city.
Scott O’Neill is the founder and director of Rethink Investing and an experienced investor with a real estate portfolio valued at $ 20 million
Disclaimer: The advice in this article is for informational purposes only and should not be considered financial advice. Please be sure to speak to a qualified professional before making any investment decisions.
