Commercial property development or investment is a business that involves a significant analytical understanding of real estate and its market conditions. To be successful in this business, it requires a good knowledge of the complex market influences at work, unique financing requirements, property management options, leasing arrangements and a good grasp of the potential risks.
The driver for growth in both residential and commercial properties is its market demand. The main difference though, with commercial property, the demand is driven by a country’s economy and its population growth. A robust economy is vital for any successful commercial property investment or development. A thriving commercial market is supported by strong national and local economies as well as international interest.
As the economy ramps up, the transport industry shows the first signs of growth. The growth is driven by the demand for materials for manufacturing and construction, and an increase in imported goods and an increase in building activity. Share prices on the stock exchange started to rise on the back of increased business and earnings, more jobs become available, and the demand for commercial space increases. As the economy continues to grow, the market will start looking for warehouse space, then retail, followed by office space.
Some people may think that commercial property is a skill, but the art of commercial property is the understanding of how a property fits in a market and how its users and its reputation perceive it. By developing or adding a commercial property to an investment portfolio, offers the private investor a good hedge against inflation. Historically, commercial property has equalled or exceeded the inflation rate. It also allows investors to diversify risk and create balance, since commercial real estate does not experience drastic fluctuations like the stock market.
The Need for Commercial Buildings
Shelter and land are fundamental to human existence on this earth. What we eat, where and how we live and what we do in our daily lives impacts directly on the way in which we all use the land. The developed world has moved well beyond land uses for the basics of life into land uses for recreation, mobility, technology and entertainment. While housing provides shelter for eating and sleeping, commercial properties offer space for people to interact socially, conduct and manage a business, storing and selling of goods and services. Below are some examples of the drivers that create a need for commercial property development.
Urbanisation – Property development is the manner of responding to real estate needs in our society by constructing and financing a product, which satisfies that need. As communities become more urbanised, there has been considerable pressure placed on housing in larger cities and towns. As these societies grow, the demand for other functions such as commercial and recreation has increased.
Consumer goods – With the ever-increasing demand for consumer goods, the need for more retail outlets convenient to purchaser’s homes has grown. Whenever a new regional land sub-division development takes place, there is invariably a new shopping centre to go with it. To support these retail outlets, there is a need for further distribution centres and warehousing required. These large buildings are usually located in industrial areas where other activities are operating. This includes activities such as manufacturing and storage of goods. With the large export of natural resources and increase manufacturing base, there will be a constant demand for such buildings.
Workplace space – The demand for office accommodation for finance, insurance and business services increases in proportion to the growth in population in a specified area. Also, high-tech companies involved in telecommunications, internet services, and media production are leading the way as today’s new tenants in markets in major cities around the world. With higher education in technology and growth in this sector particularly computer and digital occupations, it is expected that office leasing will be strong over the next decade.
Leisure – Tourism is another significant contributor to the Australian economy, generating markets for a wide variety of goods and services. In the financial year 2014/15, tourism represented 3.0 per cent of Australia’s GDP contributing $47.5 billion to the national economy. Domestic tourism is a significant part of the tourism industry as well, representing 73 per cent of the total direct tourism GDP. As this industry grows so does the demand for new buildings and infrastructure in this sector.
Mining and manufacturing – The long-term demand for industrial buildings is expected to stay active as a function of the same factors that drive the market today which include mining and manufacturing. These industries contribute significantly to the Australian economy through international trade, private investment and employment. The mining and manufacturing industries also have a significant impact on the construction industry as projects in this sector generally require substantial levels of construction activity.
Health and education – As the population increases, federal and state governments are under increasing pressure to provide health and education facilities also known as social infrastructure. With improved advancement in medical science, the older population are living much longer which places pressure on the need for new medical buildings such as hospitals and aged care facilities. Whereas the education sector is an important social infrastructure for growing communities.
Over the past decade, the Australian economy has seen a steady and healthy growth, which spells well for commercial property developers. However, the development and construction of commercial buildings will depend on the demand for specific types of buildings. While overall economic conditions influence investment decisions, the need for specific types of buildings can vary considerably, depending on expectations for future activity in the industry in which a building can be used.
Commercial versus Residential
Most Australian developers focus on the residential property market because they have been renters or owner-occupiers, so they are naturally more comfortable with this sector. However, commercial property development can be more lucrative if you have the knowledge and expertise to develop commercial buildings. Below we explore and compare the two sectors.
Valuation – Probably the most significant difference between commercial properties and residential properties is in assessing its value. In commercial properties, the value is determined by the inverse proportion to the degree of risk inherent to the continuance and stability of the income stream from the property. Whereas with residential, the value is be based predominantly on supply and demand. This means that no matter how attractive the commercial building may look or how much it had cost to build, the bottom line in assessing its value will depend on the leases and the net income stream the building produces.
Market research – In assessing the market, commercial property involves more intensive market research than residential. While residential supply and demand are localised, the demand for commercial properties are based on a macro or regional level. Commercial properties require a greater market audience to make the scheme viable.
Design and development approval – Commercial developments especially retail and to a lesser degree office and industrial involves sophisticated design and tend to attract more community objections if constructed in a residential area. Also, the building regulations applied to commercial is stringent due to the public access to these buildings. Whereas with residential the design is generally standard and attracts fewer community objections unless it is a high-rise apartment building in a lower density residential area. Based on this, the development approval for commercial projects, the process takes longer before securing approval.
Construction – Most commercial buildings are substantial in scale and made up of some complex structural elements which in the end adds to the cost of the building. Also, with its specific class and stringent compliance related to building codes, the construction of commercial buildings is more expensive. Whereas with residential, the construction methodologies are less complicated and easily understood by tradespeople. With healthy competition amongst residential builders, the cost of residential is lower.
Competition – Competition amongst residential developers is quite prolific due to the ease in entering this sector for the reasons mentioned earlier. Most commercial developers tend to specialise in a specific class. Some only develop shopping centres while others concentrate on industrial buildings. With healthy competition amongst residential makes a developer’s profit margin lower compared to commercial.
Purchaser base – The purchasers for residential buildings are higher compared to the sale of commercial property. Also, it is easier to market a residential as it can be broken down into smaller sections. For example, an apartment block can be divided into strata sections and sold to a few purchasers at an affordable price. Whereas a commercial building with comparatively similar scale, such as small office block or shopping centre would look to a single purchaser.
Finance – As commercial developments require substantial capital, the application for funding is more complex and would, therefore, take longer in obtaining approval. Whereas with residential, lending institutions have the infrastructure and systems to make home loans more accessible for the consumer to apply for. With more banks and new mortgage companies entering the market, finance for a home is a lot easier than commercial development.
Purchasers and tenants – Purchasers entering the residential market are not as sophisticated compared to seasoned investors found in commercial properties. Commercial property investors will generally negotiate actively on many issues, therefore, delaying the settlement that in turns affects the developer’s profit. An offer on a residential property is usually completed on a standard offer and acceptance executed by a real estate agent, whereas with larger commercial properties, a solicitor would be required to formalise the purchase.
Leasing and yields – Although rental growth can vary according to location, commercial property offers more excellent opportunities for rental growth than those achieved by residential properties. Most commercial leases link rental growth to the Consumer Price Index (CPI), which is not always achievable with residential property. With commercial properties, it may be possible to negotiate a specified annual rate, above the CPI. Also, all outgoings are paid a commercial tenant whereas these costs are to the account of a residential landlord, therefore providing a higher yield to a commercial owner.
Vacancy – Nothing is worse for an investor than an abnormal ‘For Lease’ sign. While residential properties can certainly be subject to periods of vacancy, commercial properties can be harder to lease due to the precise requirements of commercial tenants. Sometimes, owners who are pressed to find a commercial tenant will offer generous lease terms to make sure that the property is not left vacant. This can take the form of rent-free periods or heavy expenditure to meet the tenant’s specific spatial needs. This rarely occurs with established, inner-suburban residences where location and local amenities are at the forefront in the minds of tenants.
Capital growth – As commercial leases are linked to CPI escalation and valued according to its yield, it offers a better yield to buyers. Returns from commercial properties, particularly during boom times of strong capital growth, commercial properties can be reasonably low. Residential properties, on the other hand, is based on supply and demand which during boom times capital growth can be quite significant.
Valuation based on the net return of the property
Valuation based on supply and demand in a specific area
Market research is broader
Market research localised
Longer DA process
Shorter DA process
Standard construction methods
Less competition amongst developers
More competition amongst developers
Less opportunities for improvements
More opportunities for improvements
Smaller purchaser base
Larger purchaser base
Ease of finance
Sophisticated buyers – longer negotiations
Less complicated buyers
Longer vacancy periods
Shorter vacancy periods
Less capital growth in boom times
Greater capital growth in boom times
From the above assessment, it may seem that there are more risks involved in commercial properties. This is true from if one must generalise, but if one is knowledgeable and experienced in the commercial sector, there are better profits to be made for the same amount of time and the amount personally invested in residential properties. Remember, the higher the risk, the more profitable is the investment.
Types of Commercial Properties
Commercial properties can be categorised into the following areas:
Office buildings are rented to non-retail commercial users. These structures are designed as low-rise, mid-rise and high-rise buildings and can consist of one to 20 stories or more depending on the zoning and density regulations. The users of the office space sell and administrate a service to the public. Offices do not need a retail location and depending on their quality and finishes they can be classified a Class A, B or C offices. The following are the various types of office accommodation:
Renovated house – Homes in older suburbs converted to professional offices.
Strata title offices – These are smaller office units within an office block that is managed by a body corporate.
Office parks – made up of smaller, two to three storey office blocks, which are surrounded by well-landscaped gardens and open areas.
Multi-storey office blocks – Multi-levels office blocks, better known as skyscrapers.
While individual investors without any specific expertise frequently own small strip shops and neighbourhood shopping centres, more experienced, knowledgeable and financially able investment groups usually undertake invest in larger retail outlets. The more significant retail developments also involve complicated analysis, planning, financing, leasing and management problems. Below is breakdown of the various types of retail outlets.
Corner shop convenience store – The traditional corner convenience store generally found in older suburban areas.
Strip shopping – A continuous line of shops commonly found along major arterial routes.
Neighbourhood shopping centre (1000m2 – 5000m2) – This centre has one major anchor tenant such as a supermarket together with many smaller line shops.
District shopping centre (5000m² – 20,000m²) – This centre has an anchor tenant, which is generally a junior department store, and may include banks and professional offices.
Regional shopping centre (20,000m² plus) – Developed with one or more major department stores, this centre includes general merchandise, apparel and service establishments.
Hyper-Centre (20,000m² plus) – An extensive centre in a regional area. These centres have between two to five department stores and between 100 to 200 smaller retail outlets.
Theme Centres (size varies) – These are retail centres designed around a common theme, which can include:
Discount Centre – Tenants offer merchandise at discount prices
Factory Outlet Centre – Manufacturers sell their goods directly to the public
Fashion Centre – The tenants offer predominantly high-priced quality fashion
Car Care Centre – Tenants deal in the automobile merchandise.
Buildings that provide rental space to users of bulk storage feature minimal office space or manufacturing are defined as industrial buildings. These buildings are designed for users, which require a small percentage of office space (10 to 20 per cent) with the balance in large spanned warehouses with loading facilities. Industrial properties are broken down into the following:
Office-Warehouse: Light industrial users typically warehouse products or manufacturer and non-smokestack type product.
Service: Ceiling height up to 5 metres, drive-in loading, and 31 to 100 per cent office.
Distribution: Ceiling height 5 metres to 7 metres, drive-in and dock-high loading, and 11 to 30 per cent office.
Warehouse: Ceiling height up to 7.5 metres, drive-in and dock-high loading, and 0 to 10 per cent office.
Bulk-Distribution: Large storage space for central receiving for distribution. Direct railroad access is not necessary.
Manufacturing Facilities: Heavy industrial users typically require extra facilities for rail shipping or increased utility availability.
Mini Warehouses: Mini warehouse properties cater to users of small storage spaces. Unit sizes range from a 3 x 3 metres to 6 x 9 metres in area. These are buildings designed as a group measuring approximately up to 200 square metres or more.
Hotels and Resorts
Tourist buildings can include some different facilities that are common to all types of hotels or resorts featuring accommodation, restaurants, eateries, entertainment, leisure and relaxation.
Hotels – provide room accommodation and cater to refreshments and meals at irregular times.
Motels – located in strategic locations to provide accommodation for motorists.
Casinos – The government strictly controls these venues, and a licence to develop and operate a casino is not easily obtainable.
Entertainment centres – These centres may be individual facilities in a tourist area or a building complex.
Golf course estates – Many successful resorts in Australia have been developed around a golf course.
Marina developments – Marina and harbour developments include boating and fishing activities.
Waterfront developments – Waterfronts with commercial and tourist attractions around existing harbours have become popular.
Theme parks – Theme parks are designed to attract the day excursionist and cater for the families.
Conference centres – With major exhibitions and trade shows occurring internationally, every major city should provide conference facilities to capture this growing market.
Facilities in education can vary from private primary schools to tertiary centres such as colleges and universities with the latest developments and investments in science technology parks.
Child Care Centres: Also known as day-care centres generally located in the suburbs and catering for children at a time aged from six weeks to thirteen years.
Primary to High Schools: Developed mainly by the Government unless operated privately and therefore developed privately.
Colleges: With an increase in international students, colleges can vary from small operators to larger institutional colleges.
Universities: Every major city have several universities that are either sponsored by the government or private operators
Science technology Parks: Also known as incubation centres and generally located near universities.
Development and investment in medical facilities can be lucrative if well-located sites are found. Depending on its size, facilities can vary from small doctor’s rooms to operating theatres in larger buildings. The buildings can be categorised into the following:
Suburban Medical Centres: These practices would have either one doctor or a few partners operating their business in a suburban area.
Neighbourhood Medical Centres: Also known as GP Super Clinics, these are practices have several doctors and specialists under one roof together with nursing staff.
Private Hospitals: Generally located in up-market suburbs with beds ranging from 50 to 100 with specialist medical staff.
These are specific developments that are not ordinarily available to the average investor or developer and can include:
Petrol Outlets: Operated by the major petrol outlets and vary in size.
Parking lots and garages: Owned and operated by private investors or local councils.
Rewards in Commercial Property
Developing commercial property can be very exciting and financially rewarding. However, it is a game where the stakes are high and where fortunes are made or lost. It is game not for the faint-hearted but rather for brave entrepreneurs who are prepared to test their skills, vision and smart decision-making. It is a game where one can create a legacy with striking architectural buildings. It is a game where structures and decision-making shape our environment and communities. Below are several benefits when developing commercial property.
Higher returns – Compared to residential developments where there is a greater level of competition, commercial property generally provides a higher return on equity during the development stage and a better yield when completed if the building is fully tenanted. The average rental yield on residential properties across Australia’s capital cities is 3.6% according to CoreLogic RP Data. In contrast, commercial properties are yielding anywhere between 6% and 12% of gross rental.
Longer leases – On average, residential tenancy leases last between 1 to 2 years and some a little as 6 months, whereas with a commercial lease the tenancy period can be anywhere between 3 and 10 years. This provides a consistency of income with escalation aligned to CPI (Consumer Price Index), whereas residential rents are open to the volatility of the residential rental market.
No rates and other outgoings – Furthermore, with commercial property all outgoings such as rates and taxes, insurances, water rates etc. is paid by the commercial tenant, whereas with residential properties the landlord is responsible for these outgoings. So gross rent received in a commercial property is much higher than a residential property.
Higher sale value – Most commercial buildings are based on a development strategy of “build, hold and sell”. Whereas most residential developers have a strategy of “build to sell”. Unless a commercial developer is developing for a fund or investment group who will purchase the property on completion, most would hold and then sell when the rental income is stabilised providing a higher return on initial investment.
Taxation – There are many tax incentives for the private sector to invest in commercial property. The Australian Taxation Office (ATO) has tax laws that provide for:
The deduction of expenses associated with the development.
The deduction of interest charges.
The deduction to any property taxes related to the development.
The deduction of most depreciating items.
Capital gains tax relative to inflation.
Negative gearing opportunities.
Cosmetics are less important – A commercial property’s value does not lie in how architecturally pleasing it looks as the real value lies in the leases under contract. It is not to say that no thought should be considered when designing a new commercial building as the business tenants still need to attract their clients or customers to the building. It must be remembered that the “income stream” creates the “real value” of the property rather than expensive finishes and architectural features.
Community benefits – Depending on the type of commercial to be developed and location, the completed facility provides a benefit to the tenants and the community which a developer can be proud of. There is no direct cash benefit to the developer, however, it is the intangible reward that benefits the developer. As each new project is completed and becomes operational, the developer track record and credibility improve which then creates opportunities for repeat business.
Risks in Commercial Property
In commercial property, there are many kinds of risk. There is market risk, leasing risk and construction risk. You may also take a risk to the type of structure you are entering into, such as a joint venture. Ensure that you understand all the elements of risk you are taking on. It must be corresponding with the strategy of your portfolio and the returns that you expect to receive.
There are no magic formulae for eliminating the risk in a property deal. One must assess risk by looking at the competition, quantity and advantages your product has to offer over an existing product in the market. Critical to risk assessment is determining the specific stage of the market cycle. Several key areas of risk in commercial property include:
Larger capital risk – Developing a commercial property typically requires more capital than a residential development within the same precinct. With larger capital exposure in both debt and equity comes higher risks especially if the building does not provide the expected yield demonstrated by the initial feasibility studies.
Planning approvals risk – Commercial property developments always attract the local community’s interest which could delay the planning approval process especially if the project is controversial. The worst case is that is that planning could be denied which will cost more money especially if it is taken to a tribunal court.
Construction risk – Most commercial buildings are larger than a residential project and take longer to construction time to complete which opens to several potential construction risks such as:
Inflation and escalating construction costs.
Disputes with the contractor or sub-contractors.
Industrial disputes with trade unions.
Variations and cost over-runs.
Non-completion date which results in loss of rent
Market risk – Professional commercial developers would understand the importance of a market study before starting a new development or a bank would require pre-leasing to be in place before they advance their funds. Market risk occurs mainly at the completion of the development if there is a downturn in the economy or an oversupply of a specific commercial asset class such as a hotel or office building. This could affect the profitability of the project and the ability to repay the loan.
Limited buyers – As commercial developments are larger in scale and with less strata title offerings, the buyer market for commercial is limited to institutions or sophisticated investor buyers. Should a developer face cash flow difficulty when the building is completed or if tenants fall to pay their rent, the building would be sold for less than what was initially anticipated.
Risk Mitigation in Commercial Property
One way of dealing with risk in commercial property is by looking at the capitalisation rate. The capitalisation rate you are prepared to pay for an investment is related to risk. Where you have an “A” grade tenant in place, escalation in the lease documents and a supply-controlled market, you will be willing to accept a lower capitalisation rate than you would if you are building something from scratch. If you are in a market without supply constraints, you expect to go in at a higher cap rate than you would in a close-in market where it is tough to replicate the product.
Undertaking research – Market research into the type of commercial property and market area is essential to a successful development. Money spent or market research will always heed healthy dividends and reduces risk.
Allow for contingencies – In a feasibility study of a commercial project it is important to allow for financial contingencies as cost could vary during the development stages of a project. Allow for a construction contingency as commercial projects tend to vary in design and scale. In addition, allow for a development contingency to allow for any cost that was not at hand during the early stages of the development process.
Limit ownership liability – As a developer of commercial property, one should select a vehicle to protect oneself from personal liability. This will help to protect you as a developer from tenants, consultants, contractors and the general public.
Limit financial liability – One should try to affect nonrecourse financing for any loans applied for and use a corporate investment vehicle to shield one’s personal assets. Another method would be to find financial partners who help to carry any financial losses.
Professional team – Unlike residential developments, most commercial developments require a larger number of professional consultants as part of the development team. When selecting a development team, one should only appoint professionals who have the knowledge and experience in the type of commercial project undertaken.
Select reputable contractors – In order to ensure that the construction process moves smoothly, only select building contractors who have a good reputation and a track record of building the type of commercial building. Wherever possible ensure that the builder provides a fixed price contract.
Pass rental risk to the tenant – Draw up leases in which the tenant is liable for any increases in operating costs and escalation clauses to protect one from inflation.
Types of Commercial Developers
As seen above, there are many different types of commercial developments, and by the same token, there are many kinds of commercial property developers. They can be part-time investors or full-time professionals. However commercial developers seem to fall predominantly into the latter half. This is mainly due to the amount of time and capital involved in the commercial sector. No matter which category the developer falls under, the underlying development principles and strategies remain the same. Listed below are definitions of some typical commercial developers:
Part-time developers – This group consists of novice developers or investors who hold a full-time job or a small syndicate of friends or business associates. This type of commercial developer often develops with the aim of holding onto the development as a long-term investment. They may purchase a single lot and build a small industrial building or a small shopping centre, or they may buy an existing building, add value through renovation and by renegotiation new leases with current or new tenants. Most developers under this category will hold the developed property as a long-term investment, while a small percentage will seek to sell at a profit. Their developments are characterised by a frequent number of transactions, a small number of holdings, low equity, with the importance placed on long-term capital gain and a positive rental income.
Full-time professionals – This group consists mainly of individuals or partners who have decided to make property development as a career. They can be quantity surveyors, construction managers, project managers, builders, architects, engineers, real estate agents or ordinary people whose initial first few developments turned out to be financially rewarding. This group usually are highly geared, aware of the latest financial instruments, and seek to maximise tax benefits and capital gains from their developments. Most developers under this group focus on smaller commercial projects from strata industrial buildings to showroom retail developments and concentrate their efforts in locations with good infrastructure and convenient access to transport.
Corporations – This group includes property development companies and major financial institutions. They could be privately owned corporations, public companies listed on the Australian Stock Exchange, large insurance groups, superannuation funds or trade unions. Generally, these groups develop larger commercial properties such as regional shopping centres intending to generate profits for their shareholders through long-term capital gain and good cash flow through positive rental income. These corporations generally have many qualified professionals who seek new developments and manage the project from inception to completion. After that, the property management division will take over and ensure the smooth running of the building.
Government/Institutional – This category consists mainly of state governments and at times assisted by the Federal Government. Type of developments would be government offices, hospitals, police stations, industrial land sub-division and any other public buildings. In some State-run programs they may involve the private sector, and either look at a joint venture of tender a developable portion of land to private developers.
Fee developers – Fee developers are professional development managers with both experience and qualifications. They will contract with a landowner or group of investors to develop their property for a fee. Development managers are experienced in all phases of commercial development. They are familiar with all aspects of developments including finance, feasibility studies etc. and understand the risk involved and how to avoid them. These developers can also be part of an investment syndicate, and while they maintain a shareholding, they are paid a fee in managing the development. Fees charged for their professional service can range from 3 to 5 per cent, depending on the complexity of the project.
Land developers – In the commercial sector, land developers focus mainly in industrial areas. They buy large tracks of land, rezoned it, sub-divide it and add the necessary infrastructure and services and then sell the portions to other developers or end users.
Commercial property involves a significant analytical understanding of real estate, and its market conditions that require a good knowledge of the complex market influences, unique financing requirements, property management, leasing arrangements and a good grasp of the potential risks.
Historically commercial property has equalled or exceeded the inflation rate. It also allows investors to diversify risk and create balance since commercial real estate does not experience drastic fluctuations like the stock market.
The need for commercial property development is driven by increased urbanisation, demand for consumer goods, workplace space, leisure, mining and manufacturing which accelerates when the economy is running in a positive mode.
The most significant difference between commercial and residential properties is in assessing its value. Commercial properties value is determined in inverse proportion to the degree of risk of the income stream, whereas with residential the value will be based predominantly on supply and demand.
Like any other property development, commercial property has its inherent risks associated with development. Most commercial properties are held as long-term investments which carry additional risk although to a lesser degree.
The rewards in commercial property are many over residential, and these include higher yields, better returns or increased value at completion, and longer leases with tenants paying the outgoings.
As there are many different types of commercial developments and by the same token there are many kinds of commercial property developers. They can be part-time investors or full-time professionals.