Australia's commercial market is running hot and it's no mystery why

Australia’s commercial property market is attracting a substantial amount of capital. The nation’s outperformance is the result of a number of factors, significantly the “sheer weight of money” coming from both foreign investment and local institutions. Couple this with historically low interest rates and improved business confidence, and it’s no surprise the market’s running hot.

Like many other industries, our proximity to Asia, combined with attractive returns and the stable political and legal environment are fuelling significant foreign capital from the U.S., Europe and Asia.

But domestic institutional groups are also reaping the rewards of Australia’s strong economy, with capital markets providing conditions that allow them to attract new investment. Prime assets are in demand, meaning investors are looking for newer buildings, core locations, long leases and strong covenants. What does this mean? Heightened prices for assets that fit the bill.

Paradoxically, this is taking place in a market where the fundamentals are not so good - office vacancies in the capital cities are expected to continue to increase in the coming year before plateauing. On top of that, incentives to retain existing tenants and to attract new tenants are currently well in excess of 30% in many cities. Industrial properties are also now experiencing an increase in tenant incentives, but are well below those being paid in the office market. Office tenants’ space requirements are diminishing due to a change in work practises and the increase in outsourcing.

However, by sticking to the basics, good investments can still be found. Given the high vacancy and incentive environment, an investor should aim for office buildings with a weighted average lease expiry of at least five or six years. This should be coupled with a tenant or tenants who can satisfy a rigorous financial due diligence. The location is also important – buy where you can attract quality tenants. And be aware of the NABERS Energy rating – government and blue chip tenants have an increasing desire to locate into buildings with a minimum NABERS Energy rating of 4.5 stars.

With an accounting background, I regard myself a considered investor and advisor. Over my nearly 40 years providing financial advice to clients, I had discussions with many business people who were considering investing in commercial property. The thing I found was that some of them were abandoning the basic principles of investing and weren’t necessarily looking at all the facts, and more importantly, they weren’t considering the risks.

I’ve always stuck to a simple mantra – one that serves me well personally and professionally –‘put yourself in someone else’s shoes’.

I ask myself; if I was a potential commercial property investor, what advice would I want to receive when considering an investment in commercial property?

To be warned about following the hype: Don’t get caught up in the hype arising from the current huge volume of investment activity from overseas and local institutions. Just because others are investing, doesn’t mean you should throw yourself in without considering the underlying current and forecast relevant fundamentals i.e. rental rates, incentives, vacancy rates, tenant demand, new supply, etc.

To be advised to buy well below replacement cost: Doing so helps your investment remain competitive with other, newer buildings. It also allows for upgrades to the building and the ability to offer very competitive rentals to tenants, both of which are key to retaining existing and attracting prospective tenants..

To be warned not to get blinded by the initial yield: Don’t buy just because there is a high rental yield. Pay particular attention to the lease terms, check that the rentals being paid are not well above market rents, check on the strength of the lease covenants – an empty commercial building doesn’t pay the bills.

To be reminded of the importance of strong relationships with tenants: Look after the tenant, in fact love the tenant – they do pay the bills!

To always be prepared for let-up times: In times of subdued tenant demand, a property may stay vacant after a tenant leaves for an extended period. This must be built into the financial projections as well as any associated tenant incentive payment.

Finally, I’d want to be warned about the importance of doing my homework: The assumptions made by the promoter shouldn’t be accepted as gospel. It’s important to check whether the promoter has aligned his assumptions with reasonable market evidence of projected rental income, outgoings, let-up periods, adequate projected CAPEX and incentives over the syndicate term, as well as projected interest rates and yields.