Market Watch Volume 2, Issue 1 - Investments

Whenever we’ve spoken about real estate investment in our past series of articles, we’ve pretty much restricted ourselves to residential real estate investment. That’s the easiest form of real estate investment to buy into and for most of us, residential real estate will easily accomplish all our financial goals.

There is another branch of real estate investment which is very significant and offers certain benefits which are not available in residential real estate investment. I’m referring to commercial real estate investment. No doubt it is an area that some of you, who become serious in your real estate endeavours will want to explore. I think it would serve us well to take a brief look at this fascinating area.
 

By commercial real estate I refer to pretty well any form of real estate investment that does not involve permanent dwelling space. We could be talking about a commercial strip plaza, a specialty purpose building such as a medical clinic, a design built free standing structure like a fast food outlet, warehouse space. On and on the list goes. For our purposes we won’t differentiate between commercial, industrial or office space, but will group them all under the heading of commercial.
 

There are a number of significant advantages commercial real estate offers to the investor as compared to residential real estate. One is the lack of oppressive legislation. Residential real estate is governed in Ontario by the Residential Tenancies Act. As the name suggests, it isn’t a balanced piece of legislation. It’s there to protect the tenant. It affects when and how much a landlord can raise rent. How he can evict a bad tenant. It prevents the landlord from terminating the tenancy at the end of the lease. And so on. No such consumer protection legislation covers commercial real estate. It is governed strictly by the marketplace.


Commercial real estate generally provides better returns for the investor than does residential investment. The properties are sold on the strength of their returns, or cap rate. Under normal circumstances the leases tend to be what we call triple net leases. By this we mean that the tenant in addition to rent is responsible for all additional expenses. These include all utilities, property taxes, insurance, and even repairs and maintenance. In this way when the landlord invests based on a 10% cap rate, that rate is guaranteed to him regardless of what happens to gas prices, municipal taxes or what repair and maintenance is required to be done in the rented space, or to the common area for that matter.


And because when the tenant moves into vacant space, he is generally responsible for all interior finish to his unit, including wall partitioning and carpeting (we call these leasehold improvements) the tenants tend to stay in place longer. Leases generally run 5 to 10 years, but it’s not uncommon to have a commercial tenant occupy the same space for 20-25 years or longer.


Well, all this sounds pretty good. One might wonder why anyone would invest in residential real estate when commercial real estate is an option. There are some down sides to commercial real estate investment however. For one thing acquisition is more difficult. Generally the price point is much higher for quality commercial space than it is for residential, and banks are reluctant to finance commercial investments unless the buyer is a seasoned investor with deep pockets. Even then the banks generally won’t mortgage beyond about 65% of value. Large down payments or vendor-take-back mortgages are essential.


Perhaps the biggest deterrent to commercial investment is their vulnerability to an economic downturn. Watch in a recessionary economic climate the number of commercial spaces you suddenly see vacant as businesses close down. By the same token, economic downturns have very little impact on residential investments. People need a place to live regardless. Commercial real estate is a fascinating avenue for investment and one which can provide wonderful secure returns if the right purchases are made. We can’t possibly do justice to this topic in our limited space. I would suggest, however, as you become more involved in real estate investment that you explore this wonderful option. Here again I can’t stress enough the importance of connecting with a knowledgeable and competent real estate professional when you do.

Wayne Quirk, Author
“THE MONEY MACHINE”
wayneq@remax-gc.com