Commercial Property Investment – Pros and Cons

Commercial Property Investment is always a mystery for a common investor. There is a general perception that Commercial Property Investment is meant only for a business class or big investors. Though it is not true always. I keep receiving queries on Commercial Property Investment from the common investors. One of the most common queries is whether to go for Commercial Property or Residential for investment purpose. Trust me in 99% cases, the buyer decides in favor of a residential property. I will share the reasons later in the post. For comparison, you may go through my post, Commercial Property vs Residential Property.

One of the reasons for favoring residential property is low perceived risk. On the other hand, the perceived risk is high for Commercial Property Investment. For example, one of my clients was planning to buy a shop in the upcoming commercial establishment. Some of his friends told him that it is very difficult to vacate tenant from a commercial property compared to residential. He dropped the idea and settled for 3BHK flat. It might be true but not always.

Commercial Property Investment is a broader term and may include Shop, Office Space, Land etc. Each of them has its own pros and cons. In this post, we are discussing at the macro level. In one of my future posts, i will discuss the pros and cons of the types of Commercial Property in detail.

One of the emerging trends is leasing of the commercial property instead of outright sale by the builders. It is especially true for prime/premium locations. Builders are not willing to sell rather they prefer to put it on long term lease. The rental yield is very high in such cases. A property with 10% rental yield can help to serve the loan against the property. Once the loan is over, the property is free for the builder. Moreover, assured returns help builder to survive during bad times :).

Not all builders venture into commercial property. There is a clear demarcation. Some of the builders specialize in commercial property. Therefore it is advisable that investor should trust only those builders who specialize in commercial property. This is especially true for office space. I observed that builder is successful either in the residential or commercial space. The builders who ventured in both failed in either one.

As a layman, if you ask anyone whether to buy a Commercial Property or not, the answer will be YES always. The biggest motivation is high rental yields. Experts always quote that rental yield can be as high as 15%. On the contrary, you will not find too many people in your circle with Commercial Property Investment. I used to wonder “Am i missing something?”. If the Commercial Property Investment is such a lucrative proposition then there should be a great rush to purchase. It is not as simple as it looks. Let’s check out the pros and cons to understand in detail.

Pros of Commercial Property Investment

1. Rental Yields:

This is one of biggest plus point as i shared earlier. The average rental yield of commercial property is in two digits i.e. 10%. It also depends on the type of property like shop, office space etc. It can be a good parameter to find out whether you are buying at the right location and at the right price or not. For a premium or good locations, you may fetch a rental yield of up to 13% to 15%. To know how to calculate the fair value of the property you may check my post, Fair Value of Property – Pay the Right Price.

2. Consistent and Regular Returns:

The lease agreements for commercial property is for the long term. Normally a lease is signed for minimum 5 years. Therefore, the owner is assured of consistent returns, unlike residential property. The lease agreement carries a clause of annual increase irrespective of market conditions. Therefore returns from commercial property investment are assured in nature.

3. Tenants:

Normally the tenants are corporates, banks, business houses or retail chains if the location is good. It is good to deal with corporates as you need not run for rent and other operational hassles are minimum. Moreover, a quality tenant attracts more such tenants in the vicinity. It has a ripple effect and helps in better future rental yields.

4. NIL Furnishing Cost:

One of the key advantages of commercial property investment is that furnishing cost is NIL. You can handover raw unit to the tenant. The corporates, banks, business houses or retail chains furnish the property as per their choice/taste. The reason being branding is very critical in commercial space. For example, if i lease it to the bank then the bank will have its own guidelines to set up the bank branch or ATM.

On the other hand, if you buy residential property then basic home furnishing adds to the cost of the property.

Cons of Commercial Property Investment

1. Costly

As a thumb rule, commercial property investment is costly affair compared to residential property. Therefore, you may need to shell out more money. It is not necessary always. In some of the cities, the prices have corrected sharply. At present commercial property investment is quite affordable because of a slowdown in real estate sector.

2. Buying Process

Commercial property purchase requires meticulous planning and very thorough research compared to residential property. A buyer cannot go wrong in his/her judgment. The location and nature of business are the very important criterion. Any misjudgment can be fatal for commercial property investment. The demand and supply also play a crucial role. The overall buying process is a bit complex. In other words, commercial property investment requires sharp acumen. The future growth potential of the area decides your future returns.

3. Performance of Economy

The fortune of commercial property investment is linked to the performance of the economy. As we observed that weakening of economy reduces demand for commercial space. Though it is also true for the residential property but the impact is more severe in commercial space.

4. Loan at Higher Interest Rate

If you are planning to avail loan to purchase commercial property then you need to shell out higher interest rate. The interest rate is not fixed and depend on the risk assessment by the bank. It is normally 1.5% to 5% more than the home loan interest rate.

5. Loan to Value Ratio

For commercial property, the average LTV is 60% compared to 80% for residential property. Therefore, you need to pool more money from your pocket.

6. No Tax Incentive

Unlike a home loan, you will not get any tax benefit for the purchase of commercial property on loan. The tax benefit reduces the overall cost of borrowing. Therefore, it is one of the critical reason why investors prefer residential property.

7. Low Capital Appreciation

Though the rental yields are high but capital appreciation is low. Therefore, commercial property investment is suitable if and only if you would like to invest the money or if you are planning to setup own commercial establishment.

8. Not Easy to Sell

You may not find too many buyers for the commercial property. Therefore, it is not easy to sell. It may take long to sell.

9. Not Easy to find Tenant

The size of the commercial property is a very important factor. For small size property, you can easily find a tenant. For example, shops or small office spaces can be easily leased. On the other hand, if you have 20,000 sqft office space then you may find it difficult to lease.

10. Maintenance Issues

This is a major issue, especially for shops. It directly impacts your commercial property investment. I observed this issue in many commercial complexes. Before any purchase, you should always check on the modalities of upkeep and maintenance of the complex. As a customer, i will never prefer to visit a market/commercial space that is not clean.

Words of Wisdom:

In my opinion, commercial property investment should not be your first property investment. You should buy a residential property first as it provides financial and emotional security to you and your family. Your second property purchase should always be commercial property. The reason being, the 2nd property is mostly bought for investment purpose. As the rental yields are very high therefore commercial property investment makes perfect sense. By doing this, you will have best of both the worlds. Personally, i will avoid under construction commercial property as risk is high.

You should never buy a commercial property that is part of a residential complex. It looks quite profitable proposition but in reality, it is not the case. You limit access to your potential market and also the maintenance cost is high depending on amenities in the complex.

Lastly, if you are in retail business or buying a commercial space for leasing then you should check parking availability. The reason being, availability of parking can have a major impact on your commercial property investment. Assuming, you bought a shop but there is no parking space then you can’t expect too many footfalls.

Always remember that it is riskier to invest in commercial property compared to residential property. On the other hand, if you buy a right commercial property then you hit the jackpot. You can retire in early 40’s :). I am saying this with 100% conviction.

Alternative Investment Options:

If you don’t prefer direct exposure to commercial property then you may wait for REITs. It is expected that builders will transfer their best commercial assets into REIT. Therefore you can get double digit returns of commercial property without direct investment. Another option is to invest through PE (Private Equity) Funds. The only limitation is that min threshold of these funds is few crore rupees. It is more suitable for HNI’s.

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