The retail and office sectors were most adversely affected by Covid lockdowns, with landlords providing rent waivers and reductions to tenants to help them navigate lockdown periods. Unfortunately, not all retail businesses survived, which increased vacancy rates.
Consequently, large employers have reduced their commercial office footprint and do not sign long-term leases since most of their workers work from home two or three days each week.
Sydney CBD offices had a vacancy rate of 11.3% in Q1 2023, up from 10.1% in Q4 2021, according to the latest data from Domain. Sydney CBD’s vacancy rate is higher than the national average of 0.9%. However, some analysts estimate it could rise to 14.7% in the next three to five years or even 20% in worst-case scenarios. In the city, this could lead to lower rents and office values.
Cap rates
In contrast to residential property, commercial property is valued based on rental income (whereas residential property is valued based on the value of the land).
Based on reports from Colliers, Cushman & Wakefield, and other sources, the cap rates for Sydney commercial real estate vary by type, location, and quality. As of Q1 2023, the following cap rates are typical for different types of commercial properties in Sydney:
Sydney CBD Office: 4.8%
Metro Sydney Office: 6.0%
Sydney Industrial: 4.6%
Sydney Retail: 6.4%
In addition to market conditions, supply and demand, tenant quality, lease of income offered by alternative investment asset classes and other factors, cap rates may change. According to some analysts, office and retail property cap rates in Sydney CBD will continue to rise due to the ongoing affect COVID-19, remote working, online shopping, and vacancy rates. Buyers seeking higher yields and lower prices could benefit from this.
For example, if term deposits (which are risk-free) are paying 4.5% p.a then you probably want a return of circa 6.5% p.a. or more to invest in commercial property to be compensated for the higher risk.
For example, if the annual rental income of the property is $100,000, then the property value with a return of 6.5% is estimated as
Property Value = ($100,000 / 6.5%) x 100 Property Value = $1,538,461.54
This means that the property is estimated to be worth $1,538,461.54 if it generates a return of 6.5% for the investor.
Commercial property v government bonds
Government bonds and commercial property are very different types of investments with different risks and returns. Here are some things that you should consider before comparing the two types of investments:
- Income:Investors can earn rental income from commercial property, while investors can earn interest from government bonds. Commercial property income depends on occupancy rates, lease terms, and market conditions. Government bonds usually have a fixed income, unless they default or get sold before they mature.
- Capital growth: Government bonds don’t have capital growth potential, because they’re redeemed at face value when they mature. Commercial property can appreciate in value over time, depending on its location, quality, and demand. Government bonds can gain or lose money if they’re sold before maturity, depending on interest rates and bond prices.
- Risk: Since commercial property is subject to market fluctuations, vacancy rates, maintenance costs, tenant issues, and other factors, it’s usually considered a higher-risk investment than government bonds. Bonds issued by the government are generally considered low-risk investments, because they have a low probability of defaulting and are backed by the government’s full faith and credit. Government bonds still face interest rate risk and inflation risk, which can erode their real returns.
- Liquidity: In general, commercial property is less liquid than government bonds because it takes longer to sell a property and costs more to sell it. In general, government bonds are considered to be more liquid than government stocks, since they can be traded easily on the secondary market.
- Taxation: Taxes may differ from investor to investor when it comes to commercial property and government bonds. For example, commercial property investors may be able to claim depreciation and other expenses as tax deductions, while government bond investors might have to pay tax on their interest income. When you sell a commercial property, you might have to pay capital gains tax, but if you hold your bonds until maturity, you might not.
When comparing commercial property and government bonds, you’ve got a lot to consider. In the end, what’s the best investment depends on your financial goals, risk appetite, time horizon, and diversification strategy. For more advice and guidance, consult with a financial adviser.
The lending criteria for commercial properties
The lending criteria for commercial properties in Australia may vary depending on the lender, the type of property, and the borrower’s financial situation. However, some of the basic things you need to have approved to get a commercial property loan are
- Details of any existing lease, including the length of the lease term
- If the property does not have a tenant, you need to demonstrate how you will afford to maintain the property and make repayments
- Your capacity to repay – all of your income including expected rental income from the commercial property
- Your deposit and any available equity
- The type of commercial property – whether it’s a factory, office, warehouse or shop-front and its location, together with a valuer’s report.
Some lenders may also require a business plan, financial statements, tax returns, and other documents to assess your creditworthiness and suitability for the loan. The interest rates, fees, and loan terms may also differ from residential loans. Generally, commercial loans have higher interest rates, shorter loan terms, and lower loan-to-value ratios than residential loans.