Investing in Commercial Property

What are the different characteristics between investing in Residential and Commercial Property? Stefan Angelini discusses the intricacies of investing in Commercial Property with Guy Naselli from NSL Property Group.

Stefan Angelini Hey, everyone. Welcome to an episode of Real Wealth Podcast, a YouTube show. So I'm Stefan Angelini, your host from Angel Advisory. We're talking about commercial property today. So commercial property has been probably one of the most hot topics, I would say, over the last three years. And the reason being is everyone's running towards the asset class, but also has been amazing returns in the space. So I guess there's a lot more conversations around it. And here to talk about it with me, I've got the lovely Guy Naselli. Hey, Guy, mate. Guy Naselli Yeah, very well, Stefan. Thanks for having me. Stefan Angelini Good well, mate. So what of experience in the commercial space, but rather than me talk about it, could you tell us about sort of what's your experience in the commercial space and what do you do now? Guy Naselli Yeah, absolutely. So I've come from a background in construction. Originally, building engineering was the education that I got from there, got into residential real estate. So I got to appreciate what it's like to knock on residential doors and sell residential over a weekend. So certainly some of the intricacies of that, but of recent times and over the last probably 15 years, it's been commercial real estate. Over the last probably ten or so years, I worked for one of the largest agencies and figured no better time to start your own agency than three years ago, just before COVID And then that's when NSL property group was born. So, yeah, it's been a great journey. Stefan Angelini Especially when it's become so hot. Guy Naselli It has. Stefan Angelini I think about, I would say my preferred property asset class is commercial. I love it because there's no headaches and income is good. And I've realized is that while capital growth is amazing, I really like income for coming through the door. It just makes you feel better. My first experience with commercial investing was actually bought a property in my Self-managed Super Fund and it was a factory. Guy Naselli Awesome. Stefan Angelini And it was out in Mill Park. And this was when you could first use borrowing in your Super Fund, when the big banks were doing it. And it was a great investment because we could just buy it and we didn't have to do anything until we sold it. Guy Naselli How good is that? Stefan Angelini And I guess that's been a lot of the appeal to people, is that if you buy a commercial property, part of the lease is the tenant basically does everything right. Guy Naselli Spot on. Yeah. So that's one of the real benefits that we're seeing especially, and we'll probably touch on this later, but coming from a residential background, tenants pay for everything. It is a net lease. So when we say you collect your rent, but on top of that there's the outgoing. So your water rates, insurance, body corporate, if there is, they're part of the outgoing. So it really is a net plus outgoings lease, which for many landlords, it's a set and forgetting investment, which is what you're talking about. Stefan Angelini So if you look at owning commercial property versus owning a resi property, residential property, you collect, let's say you earn it's worth a million dollars. You collect 50 grand a year in rent. Then you've got property management fees, water fees, council rates, land taxes, maintenance, whatever else comes on to it. But it's a lot simpler on the commercial side. So what are some of the outgoings that are normally on the commercial side? Guy Naselli Yes, certainly some of the things we just spoke about. So outgoings or your statutory charges. So your council rates, water rates, insurance if there is body corporate, then that's certainly part of it. In many instances, especially around the city fringe locations, there's a car parking levy that the council is imposed. So that again is paid by the tenant. The difference with the residential is that if you're looking at an example, 50k per year, the landlord has to foot the bills of all those costs, whereas under a commercial lease, it's 50 plus all those costs. So your net position or your gross position is certainly a lot better. Stefan Angelini So most of the time you get that 50 grand without anything else taking off it Guy Naselli Absolutely Stefan Angelini Resi space. A lot of other things come off it. Guy Naselli Yeah. You get your transaction summary and it's less, less, less. Stefan Angelini Yeah. And you look at, when like when you sell a residential property, like, a lot of people have done really well investing in residential property because capital growth over time has been larger. Because more people buy houses, Guy Naselli Yeap Stefan Angelini There's more people out there that want to buy it. People that own commercial properties might be larger families, business owners, those kinds of things, because, well, the tenant needs to be normally a business. Guy Naselli Absolutely Stefan Angelini Right. So it's harder to fill that as opposed to just a general person moving in. Guy Naselli Yeah. The criteria to get into commercial property is somewhat a little bit more challenging and that's why a lot of people gravitate towards residential. We often say that the residential sector is a lot sexier than commercial, but certainly once you're in it, we get a lot of investors that make the transition back to commercial for simply those reasons. So probably a little harder to get in. But once you're in, you really enjoy the benefits of it. Stefan Angelini Yeah. And just recently there's been pretty big changes since the Residential Tenancies Act. So now you no longer have a renter, you've got your rental provider. And that means like, the tenants got a lot more say, which is very different from investing commercial because it is normally a set. And forget you've got a lease. Right. It's a legal document that says this is what you do, this is what I do. Is that sort of the best way to explain the difference in the kind of tenants and how the agreement is? Guy Naselli Spot on. Yeah, it's a good analogy. I mean, the name says it all. It's a Residential Tenancy act. So it's there to favor the tenants. So some of the privileges that a landlord had are being taken away. So for many people it's too onerous and they said, no, let's deviate and move to another sector. And that's why commercial has been so popular. Stefan Angelini You look at normal residential, when you lease out a residential property, you normally take a one year lease for a tenant and then you can go back and renegotiate that rent. When that year is up, they can decide to leave, stay on, go on a month to month. Commercial is a bit different. Guy Naselli Yeah, certainly. So one of the benefits of a commercial lease is the tenure. So in many instances, many of the businesses, if they're going to set up twelve months, is a fairly short term. By the time you invest capital, you put works into a building. So many of the leases we see are three years and above. It's not uncommon to see some large organizations, five x five x five, some ten year leases. What that means is that you've got a sticky tenant and as a landlord that's perfect. You don't have to go through the process of re-advertising, looking for tenants, screening, which that in itself can be a bit of a challenge for many landlords. So certainly the ability to find a good long term tenant is one of the attractive parts of commercial investing. Stefan Angelini And this is something that I do get confused about. So you can have multiple different lengths of tenancy. So you got a five x five x five. So you've got a fixed term of five years at that five years. Is that a renegotiation period or what does that mean at that next time that comes up? Guy Naselli Yeah, so you get the benefits of increases twofold. So under a five year lease, to use an example, there will be incremental increases along the way. So it could be CPI, it could be a fixed increase of 3 or 4%, which is calculated annually for that first five years. At the end of the five years, if the tenant chooses to take on that next option of another five years, then the landlord has the option of a market review. So they basically go out to market, see what the rents are doing in an immediate precinct, and between negotiation, that's what gets adopted. So not only are you getting the little increases along the way every year, but certainly at the end of that five-year term you've got the benefit of a real jump, especially if the market's flying. Look at these at the moment. So it's what we call a win-win situation then. Stefan Angelini Then you got different lengths depending on the kind of asset. Now I've got factories that are at a five-year lease, disability center, a ten-year lease, and I'm building a special-purpose childcare center. We've got a 25-year lease. And I guess the reason for that is because when you're purpose-building an asset, it there's not as many tenants that can.

Stefan Angelini Come into you certainly need to lock in that tenant and that's from the, from the owner's perspective, you want to make sure you've got security of the income coming through the door for a long period of time. And that's where if you look to depending on the kind of purchaser that's going to come into the asset at the end of it, a lot of people prefer that longer-term lease than the shorter one because you don't know what's going to happen in five years. Guy Naselli That's right. But it goes both ways Stefan, so in many instances we get tenants that say, listen Guy, I'm not interested in the short term. We're going to pump a lot of money into this business infrastructure, building a database business, a business case around a certain asset, whether it's childcare or any other, even industrial. So the last thing that a tenant wants to do is pick up and move. Certainly if you're dipping your toe in the water, then the size of the asset dictates this a lot smaller assets, probably a shorter term lease. But we've seen many real sticky tenants that want to stay there for five and ten years plus. And as a landlord, that's just a bonus because it really becomes a set and forget investment, which is what we're all after. Stefan Angelini Yeah. And let's let's look back on the last few years. So this is 2022, 2023, where people might be listening to this. It's been a stellar time both in residential, but probably more it's more impactful in commercial. We've seen sort of cap rates get squashed. It means the value of the property goes up when you're selling it. I would say the main reason behind that is the Reserve Bank cutting interest rates becoming a more appealing it's a more appealing asset when you've got long term income stream backed by property. A lot of families like that. Is that what you've been seeing? Why have people been running towards commercial? So why has there been such an appreciation? Guy Naselli Yeah, and it's a traditional asset class that's probably been undervalued, I think is the best way to describe it. But it's become now more affordable. So I'll give you an example. So where as a company involved in a lot of multi unit estates, warehouses that start from 600, 650 offices that you can purchase from 350, there is not much residential now that you can buy that gets you a 5% yield at that level. So certainly it's been an education process. But you're right, the government has identified as commercial as a real big sector and it's one that they've really pushed hard and certainly the interest rates being reduced has led to that. But it's become more educated people as a public sector, we're becoming more educated in that asset class. Traditionally, residential is subject to probably more ebbs and flows as we're seeing now. Obviously we're coming off the back of an election. If the market starts to tightening, then probably the residential market feels at first the commercial market is less likely to get the really significant peaks, but likely it's not likely to drop as quick. So it's a bit steady as she goes. And certainly for a lot of landlords, if they're playing the long game, then that's perfect as well. So it's a real combination of factors. Stefan Angelini And the way I see it is the typical owner of a commercial site, generally people that like to have lower debt levels because one banks won't give you as much money most of the time when you're borrowing for a commercial property, therefore you need more cash, more cash in. It means you can afford an impact on the market if that happens, therefore you're less likely to sell if things do happen. But I'll just want to focus on really probably one asset class that's sort of just shun big time in the commercial space. And when you look at different kinds of assets within the commercial space, for people that don't know, I mean, you've got offices, you've got special assets or specialist assets. You could go to industrial and factories, for example. That has just shun brighter than any other light in the space, hasn't it? Guy Naselli The golden child. Stefan Angelini And if you look around the world, there's been a real shift towards online Covid exacerbated that Covid just made it happen really fast because everyone started ordering online, which means ecommerce was a big push. The people needed space to store things, but only that food producers, food producers need big warehouses. What are you seeing has been the main drive towards this warehouse factory time the work going on. Guy Naselli Absolutely. Yeah. So it really is the poster boy of commercial at the moment. If you own a warehouse, the vacancy levels, it's at an all time low. But yeah, just to touch on some of the other aspect classes. So officers are feeling the pinch gone as a need for people to work in major offices. So one thing that Covid did teach us was the ability to rediscover our neighborhoods. So people are gravitating back to their neighborhoods and what's around there. Retail. So the retail strips are probably another one that's probably undergoing a bit of change. Whereby and to answer your question, nowadays so many businesses have thought, okay, with less passing traffic and less people out on the roads, let's be creative. So they've invested in some really terrific online portals, whether it's a website, podcast, which is what we're doing at the moment. So they've become sophisticated in getting a product out. They realize that they still need a warehouse, even if it's in the back streets, to get their product out. So gone are the days where you need that main road frontage. They're investing the money that they would otherwise have on a shopping strip towards a really clever website, driving more traffic through the social platforms, whether it's LinkedIn all of that spending money on Google AdWords, but the product still needs to go out. So to describe industrial, it's the perfect storm. We had developers developing less during Covid because of the uncertainty, especially two, three years ago. So with that created pent-up demand. So the few warehouses that were available for sale or for lease, if you wanted to get in there, you have to pay. But also people see it as a safe bet. It's literally, and to use an analogy, it's four walls, a little office and a roller door. And many of the clients that we deal with said, look, if I can store the stock, I can sell it. So that's why it's become so popular. And it's also an education piece, which is what we were talking about before. Gone are the days that people thought it was unsexy to have a warehouse. Now, some of these places have amenities no different to an office complex. There's some amazing gyms that operate within industrial complexes, cafes. We hear of some that are having childcare and other amenities. So all that becomes almost a mini, mini community within an industrial hub. So it's really become a lot more sophisticated than it was probably 10 or 15 years ago. Stefan Angelini Yeah, and just so many people still needing access to more space and more warehousing. You said there's not many tenants, there's not many available spaces. I mean, we invest into some, some larger funds for our clients that don't want to own assets directly. So they've got an industrial fund, for example, weighted average lease expiry of 13 years. So the average lease they have within their portfolio is 13 years. Huge. It's 100%. There's 0% vacancy, so it's fully let as well. And then you've got rental increases in there that sort of add to it. And I guess so what we do from an economical perspective for our clients, we sort of assess, all right, well, so what's happening in the commercial market now? What's happening with interest rates? And what sort of a discount do you need to apply in order to see where commercial markets are going? So if we look at like a risk-free government bond is trading at around about 4% at the moment, still you're seeing properties sell at a 4% cap rate. Now, as an example, if you look at to explain a cap rate, if you sell a property for a million dollars and you're getting rent at 4% Guy Naselli Yeah. Stefan Angelini Or $40,000, that's a 4% cap rate, am I right? Guy Naselli Spot on. Stefan Angelini All right, so if you're getting a risk for a government bond, but then you're selling property still at 4%, you've got an underlying asset there. And historically commercial properties have added on a 2 to 3% sort of buffer on top of the risk free government bond rate, right? Guy Naselli True. Stefan Angelini But it is more than that when it comes to valuing a commercial property because it's dependent on the underlying lease. So we're seeing a lot of these cap rates getting stretched a little bit and moving out to 4 to 6%. It's starting to happen in the market. The industrial space is a really interesting one because you got rent reviews Guy Naselli Yeap Stefan Angelini And when you've got low vacancy, rents will most likely go up. Guy Naselli It does. Stefan Angelini And then what happens when rents go up? Guy Naselli Your cap rate goes up. Stefan Angelini That's right. So you can still make money. And I guess there's a lot of people out there that are still bullish that even though there's talks of recession and cap rates getting pushed out and less valuable properties, it's a really interesting one with this asset class because there is rent increases, especially if you've got a lease that's linked to CPI. Guy Naselli Well, at the moment, yeah, CPI is flying. And you're right. So those couple of mechanisms that you just spoke about, even if you're not getting the capital growth in an idle warehouse or facility, you're picking up those increases purely just by rental growth. It's not uncommon if the rent, especially if you're on a shorter term lease where you can have a couple of market reviews. All of a sudden the building hasn't changed. But that rent that you started off as initially X is now Y. So people have made money just purely over a couple of years on that rental return. And if they did decide to sell, then certainly that's a big factor in getting that extra income. Stefan Angelini And that means a lot of people because of these rent reviews. A client of mine renting a warehouse, paying $150,000 in rent. Landlords come to him at the rent review and said it's going to 220. So he goes, well, I'm not going to pay this anymore. I'll just go out and try and buy my own factory, which brings more demand into the space and hopefully, I guess, more people want that kind of an asset. Guy Naselli Spot on Stefan Angelini That's a really interesting time, but we've spoken a lot about sort of education and about different asset classes and what's happening, but I guess as an important one for people that may have commercial properties and that may believe in the space or want to get out. You've written a book. Guy Naselli Yeah. Spot on Stefan Angelini And it's a free PDF on things to think about. What is it when you're selling commercial properties? Guy Naselli Yeah, we call the strategic selling, which is essentially how to maximize the price of your commercial property when you're selling. The reality is coming from a residential background, if you owned residential property, there is so much literature out there on how to get the best price for your residential asset, whether it's brewing coffee during an open for inspection or baking bread or the whole marketing piece. In commercial, there was actually a gap in the system where there was no one document or one easy to read guide for owners on how to maximize their price. So, yeah, it's been a labor of love, but we've put together a book that's available free as an e-book for for anyone that's interested. So spot on. Stefan Angelini So give us three, three top tips. Guy Naselli Yep. Stefan Angelini What's in the book? Give us three. Guy Naselli When you purchase, think of the end at that time. So what's the flexibility with the property? A lot of people get locked into an asset that has limited flexibility. So can it be developed? Can I get plans and permits? Do I have the ability to lease it out to a multitude of different tenants? So flexibility is the key, location, certainly purely by supply and demand. If you're buying further out, then you've got more competition. Anything city fringe lends itself to a higher return. But then also, looking at the zoning, a lot of commercial properties may see it on an industrial three-zone or could be mixed use, which then allows you to then have that upside if you do decide to develop. So we talk about having the end in mind when you're purchasing. So I think the same rings true, but there's also some little nuts and bolts that you can think about in terms of marketing. Do you go expression of interest versus auction. Is a private sale of the best method? So there are a couple of different systems in place that may be better suited to one asset class versus another. So we've summarized it into one easy to read book and it's available for anyone that's interested. So spot on. Stefan Angelini Cool. I'll leave it there. So if anyone wants access to it, feel free to reach out to [email protected] and I'll flick them a copy of your book. Guy Naselli Perfect. Stefan Angelini Now, it's been a really great chat. Before we sign off, I need to do a general disclaimer. Is any information you've heard in this podcast or chat is just general information? Please don't consider it as personal advice. If you're seeking personal advice, go speak to your licensed financial planner. Financial adviser. So always got to end it with that. Mate, thank you so much for your time. World of knowledge. We're looking forward to catching up soon. Guy Naselli Good evening. Thanks, Stefan. Thanks for having me on. Cheers