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5 Things That May Affect the Return on Your Commercial Property
Prime real estate in CBD and city fringe areas remain hot property for investors, and return on investment (ROI) is often the main driver of decisions.
In 2018, a research report put together on commercial property by BIS Oxford Economics found that Sydney offices will deliver the greatest profit returns to investors over the next five years, leading up to 2023.
And, according to a new report which ranked Australia’s major markets, commercial property was a better investment than residential and the next best returns after Sydney were to be found from offices in Melbourne and Canberra.
So, it’s clear that commercial property investment has good potential. But how is ROI calculated and what factors can affect your return on commercial property?
Yield is an important calculation that tells you your rate of return as a percentage of your property’s cost or market value. It can be calculated in two ways:
Gross yield is the yield on an investment before fixed and variable costs. To work out your gross yield, divide your annual rental income by the total property costs. Multiply this figure by 100 to get the percentage value.
Here’s a working example of gross rental yield.
If your rental income for the year was $10,000, and the property purchase price was $200,000 the gross yield is $15,000 / $200,000 = 0.075 x by 100 = a gross yield of 7.5 per cent.
Net yield considers all the fixed and variable costs that come with owning an investment property including:
- Insurance expenses
- General maintenance
- Vacancy costs
It’s a more accurate way of determining yield but is also much harder to calculate as variable costs can be hard to predict.
To work out your net yield, multiply your weekly rental rate by 52 weeks (minus your fixed and variable costs) and divide by the property value. Multiply this figure by 100 to get the percentage value.
Understanding the type of yield being calculated (and the types of costs being included and excluded) can help you decide whether to invest in a property. As a benchmark, commercial offices in the CBD and fringe areas currently average around between 5-6% yield. And, generally speaking, higher yields result in higher profits but come with greater risk.
Businesses incur two kinds of costs — fixed and variable. And commercial property is no different. So, when calculating the actual return on your investment, consider:
- Fixed costs – which include things like purchase expenses, stamp duty, insurance and taxes.
- Variable costs – which can include things like fit-outs, general repairs and maintenance, interest and loan repayments, loss of rental income (if the property becomes vacant), rates, and property management fees.
The main risk you take when investing in commercial real estate is vacancy.
Vacancy rates fluctuate and are impacted by a number of factors including the size of the property, the lease and the market supply/demand. As a rule, the higher the vacancy rate, the lower the yield and the longer it will take to find a tenant.
While you cannot control fluctuations in market vacancy rates, you can reduce your risk for vacancy by securing a good, long-term tenant. Read more about how to secure the right long-term tenant for your investment property here.
Another issue to consider is if you have a larger commercial space with multiple tenants. There is a lot more to manage here than with residential property or a single commercial unit. Each tenant will have their own tenancy – most likely starting and ending at different times, more maintenance issues, common areas to look after and keep up-to-date, plus potential conflicts between tenants. In this case, you may find it helpful to hire a property manager.
4. TAX OBLIGATIONS
When leasing out a commercial property, there are various tax issues that can affect your return on investment. Consider:
- Capital Gains Tax (CPT) – If you sell your commercial property and make a profit, a CGT is usually payable on the sale of your property. The amount you’re required to pay will vary based on the profit you made from the sale.
- Gearing – Positive gearing occurs when the rental return is higher than expenses. If your property is positively geared, you will need to pay tax on the return you make. Generally speaking, a positively geared property has lower capital growth. Negative gearing, on the other hand, occurs when rental income is less than the expense of outgoings (like interest repayments and building maintenance). If your property is negatively geared, it means you are losing income and may be eligible for a tax deduction. It’s worth noting that some politicians are campaigning to abolish negative gearing in Australia.
- Tax deductions – As a landlord, you can usually claim tax deductions for a wide range of expenses, including insurance, maintenance and repairs, loan interest and fees, rates, advertising and property management costs, and depreciation.
- GST – When investing, you may also need to register for GST. Visit the Australian Taxation Office (ATO) website for more information.
5. CAPITAL GAIN/CAPITAL LOSS
Capital gain is the profit you make from the sale of your property. Conversely, a capital loss arises if the proceeds are less than the price you paid. In your tax return, you can offset capital gains against capital losses.
If you’re looking to make substantial capital gains, invest in a property with room for improvement. In this case, it can pay to be strategic and plan carefully. The improvements you make can even be simple alterations rather than structural or extensive refurbishments.
For example, look at upgrading the lighting, the building signage and exterior. You could also improve the car park, add better security systems or update appliances. For bigger changes look at how you can optimise the space, or if a change of use might increase value in the local area.
But remember, you pay tax on your capital gains, and higher capital gains generally reap lower yields.
Remember: Though the return on investment is an important consideration when investing in commercial property, there are many other factors that need to be reviewed. If you’re a first-time buyer, educate yourself with these 5 commercial property tips for first-time buyers or use this checklist to make sure you’ve dotted your Is and crossed your Ts before you buy. You can also use this article as a guide to commercial real estate tax.
Already a seasoned investor? Find out why it’s important to diversify your commercial property portfolio.
TGC has access to a variety of office spaces in Sydney and an experienced team of commercial property experts who are happy to answer any questions. Contact us or call on 1300 458 800.
Not sure whether to buy or lease commercial property? Weigh up the pros and cons here.