By Cam McLellan
For anyone looking to build wealth I strongly recommended residential property to be the basis of an initial portfolio. A residential portfolio not only offers the best market growth (over the recent decades), but it also provides the best rental stability. It is however, important to understand the other main types of properties.
The Big Three
- Vacant Land
Purchasing vacant land on the fringe of the urban growth boundary (UGB) and rezoning, or identifying infill areas for potential subdivision, are sometimes excellent strategies for creating instant equity. Unfortunately, this activity also requires a lot of skill and knowledge to ensure you succeed. Far more skill and knowledge than it takes to build a simple portfolio.
“What’s the urban growth boundary?” The UGB is the boundary set by government to control development growth. Urban to regional, high density to low density.
The main disadvantage of purchasing raw land is that there is no rental income (unless your land is primary producing, meaning farm land). This makes it difficult to support the loan repayment.
Although land subdivision and development are a large part of my life nowadays, development isn’t required to build a strong portfolio. Remember, development is not a passive investment strategy; its main purpose is to be income producing. Development is a profession, not an investment strategy.
Many people get stuck trying to find that one big score. They think development is the answer. What people don’t appreciate is that there are risks associated with every step. You need specific industry knowledge to ensure you succeed in this area. Development is a trade on its own. There’s little room for error when conducting a due diligence (DD) and feasibility on a site. Land subdivision and development is a whole other story.
Commercial covers nearly every property that houses business operations; offices, industrial (factories), retail, etc.
Before I steer you clear of commercial property until you’ve built a residential portfolio, you should know that we’ve built a separate portfolio for commercial property and we also manage syndicated funds that hold commercial property developments. We have a number of these types of projects underway currently and have found commercial and industrial property to be solid asset types. We’re currently completing final design plans for the construction of a modern multi-level office complex with basement car park and retail outlets on the ground floor in one of Melbourne’s activity centres.
I’ll discuss some advantages and disadvantages of commercial property, but when investing in any of the property types, it’s worth keeping in tune with state and local council planning websites. There’s lots of good information to be found. Melbourne’s Urban Master Plan has pin-pointed six central activity centres (Box Hill, Broadmeadows, Dandenong, Footscray, Frankston and Ringwood). There are major revitalisation plans currently underway in these centres. The reality is that people just don’t need a city business address anymore.
New South Wales are currently undertaking urban redevelopment in Newcastle, Granville and Redfern–Waterloo.
In Queensland, urban renewal plans are now underway with more than 1000 hectares of prime inner-city land being redeveloped. Current planning areas include Eastern Corridor, Fortitude Valley, Kangaroo Point South, Milton, Newstead, Teneriffe, South Brisbane, Taringa–St Lucia, Toombul, Nundah, Toowong, Auchenflower and Yeerongpilly.
Western Australia has a number of projects currently on the go in Perth, including Claisebrook Village, East Perth Power Station, New Northbridge, Perth Cultural Centre, Riverside and Perth City Link.
Please note, I do not recommended all the above areas to be investment worthy. In fact, some are very poor investment choices. All I’m showing is that there is lots of great information on the council websites. Please don’t expect these websites to blow your mind, but you will have a big advantage when investing if you have an understanding of the government’s planning strategy. It’s always good to understand the bigger picture when you want to eliminate risk while investing.
There are three main reasons why I strongly recommend that you leave commercial property alone to begin with.
1. Tenant stability and vacancy rate.
Your tenant is only as stable as the industry that they’re in and then only as stable as the people running that particular business. Ensure that you take a good look at the financials of anyone wanting to lease your property. Taking this into account, ensure that you understand business financials or get your accountant to review them for you. Be very aware of the failure rate of start-up businesses when considering a tenant.
2. Valuation assessment.
Commercial property is valued predominantly on a calculation of its rental yield. This being the case, it’s very difficult to reduce the asking rental price to entice new tenants, as you would incur a drop in the property’s valuation. There are likely to be long periods of time between tenants. Six months is not uncommon. Remembering our reliance on rental yields when building an initial portfolio, you may find it difficult to afford to have such a large valued property sitting vacant with no rental income. Expect a serious decrease in value when interest rates rise and the demand for commercial property softens. Be prepared for this, keep your gearing low and have enough cash available to service your debt. Be prepared if the banks come knocking asking for some of their money back if prices drop.
“What does gearing mean?” Gearing is simply a term that is used to describe the loan to property value ratio, a low gearing means a lower amount of borrowings against a property, etc.
Banks realise that commercial property is a higher risk investment than residential property. Therefore they usually only lend at around 60–75% of the value of the property. This means a much larger deposit is required to purchase.
Commercial properties have two main advantages over residential property.
1. It’s easier to find a commercial property that once tenanted, is positive in cash flow and still has strong growth potential. Be aware that commercial property cycles move differently to that of residential and have slightly different factors that affect these cycles.
2. The tenant has the responsibility to maintain the property. Basically all you provide is a vacant shell and they fit out the building and then ‘make good’, which simply means the tenant must bring the property back to a clean vacant shell at the end of the tenancy.
Investing in commercial property is a higher risk than residential and remember our initial wealth building strategy is all about minimising risk. Ensure you consider yourself a smart investor in the residential space before you start to learn the factors that affect commercial.
Focus on residential property as your primary form of wealth building. Later you may wish to build a commercial portfolio separately. Do this when your equity and cash flow are in a strong position. Remember, stick to your plan and you will achieve what you need to enjoy life. Don’t get side tracked with other forms of investment until you’ve built a strong foundation of residential properties.
• A residential portfolio historically not only offers the best market growth, it also provides the best rental stability.
• Development is not a passive investment strategy; its main purpose is to be income producing.
• Investing in commercial property comes with a higher risk than that of residential. Remember our initial wealth building strategy is all about minimising risk.
• Stick to your plan and you will achieve what you need to enjoy life.