In contrast to residential real estate, commercial real estate is lesser-known despite the wide range of building types it covers. Typically surrounded with unfounded rumours that commercial real estate is not worth investing in, many aspiring investors have sought to focus their real estate portfolio on residential properties – avoiding commercial real estate.
In reality, commercial real estate is worth every consideration because of its consistent rental returns, long-term tenancy and greater growth potential. However, aspiring investors should be cautious that not all commercial real estate are equal and should put in sufficient consideration before purchasing them.
Knowing what to buy, how and when is important to ensure your invested capital do not go to waste in the long run.
Types of Commercial Real Estates (CRE)
Generally, there are 5 main types of commercial real estate in Malaysia – offices, retail lots, industrial buildings, warehouses and other specialised buildings. To simplify understanding, commercial real estate is used for the sole purpose of commerce where tenants rent the property from the landlord to run their businesses.
Different from residential real estate where residential property’s sole function is reserved for residence and shelter and should not be used for commerce. In fact, there are regulations around the trending culture of “Business from Home” – stipulating that residential property should first and foremost be for residence with no more than 40% being used for commerce purposes.
Here are the different types of commercial real estate in Malaysia,
- Offices
- Retail property
- Warehouses
- Industrial buildings – laboratory, manufacturing lines or factories
- Specialised buildings – hospital, hotel, and etc
1. Office Spaces
Office spaces have always been reputable in providing consistent rental income over the long term, with most tenancy agreements being a 3 years commitment with another 3 years on renewable terms (also known as a 3+3 tenancy agreement). If you are fortunate to get your office rented out as the headquarter or head office, you may have just got lucky with a lease tenure that could go up to 8 years with the subsequent possibility of renewal.
In some cases, office spaces with special statuses, such as MSC status, have the potential to demand better rental rates. Technology companies with an MSC status address enjoy numerous business benefits, compliments of the Malaysian government.
Below are some of the key benefits for MSC status companies,
- Allows unrestricted employment of both local and foreign knowledge workers
- Competitive financial incentives, including Pioneer status which comes with 100% tax exemption for up to 10 years.
- World class physical and information infrastructure
In Malaysia, we have a number of variations to the regular office space – Small office Flexible office (SoFo), Small office Versatile office (SoVo) and Small office Home office (SoHo).
I personally am not in favour of these office variations created by developers to entice the casual investor. These offices are usually too small for any corporate to run a proper business, making it a poor choice of investment. In a 2017 study by the CBRE Group, Inc., analysts found that the term length of a lease was proportional to the size of the office space leased.
Among many factors, some tenants with requirements for large spaces will enter into a long term lease due to the limited availability and administrative hassle involved in searching for other office spaces.
2. Retail Property
This category of commercial property includes small neighbourhood malls, regional malls with anchor tenants, single-tenant retail buildings or independent development for retail purposes. The nature of investment returns is the same as office spaces with most tenancy agreements being a 3 years commitment and subsequent renewable.
However, retail properties performances are highly dependent on the economic cycle. A downturn in the economy can force businesses to close down, with tenants moving out of your retail property. This is something we experience during the COVID-19 pandemic, the F&B industry was hammered badly with eateries closing down one after another.
If you are investing for the long term, it is perhaps the best time to buy retail properties in an economic crisis and have them rented out at a lower rate. While it is true businesses are shutting down one after another, there are also new startup eateries that are willing to take the risk due to the lower rent and the convenience of modern technology. Once the economy recovers, there is still room to increase rent to the market standard, giving investors a better rental yield.
With retail property mainly targeting the retail businesses, it is ideal to buy into locations where foot traffic is high with multiple crowd cycles throughout the day. Such examples can be locations nearby to frequented MRT stations. business hubs or congested traffic hinting at a busy location. Historically, businesses are often seen to do better in these locations and have a trickle-down effect on the growing property value and rental yield.
3. Warehouses
Warehouse property is a trending topic in today’s economy. With the logistics business growing at an exponential rate in Malaysia, we are seeing strong demand for general-purpose warehouses for storing goods in transit. Besides that, warehouses can also be used as the supply hub, supporting manufacturing or industrial unit operating nearby.
Typically, leases on warehouses come with a lock-in period of 5 years and a lease tenure of 10 years. If the property is leased out to an established player in the logistics business, the landlord can expect to have a stable income on investment for the next 5 years.
4. Industrial buildings
This category of development includes large R&D facilities, distribution centres and typically large manufacturing lines.
The key benefit to investing in industrial buildings is the lower competition. The supply of industrial properties is scarce in comparison to other commercial properties with tenants being more willing to lease industrial properties for a longer time. In most cases, tenants are willing to do 10 years leasing commitment because of the work, time and money needed to set up a factory.
When it comes to investing in industrial buildings, it is important to choose locations nearer to seaports or airports to reduce logistics time and cost. Manufacturing lines such as semiconductors, pharmaceuticals and batteries will benefit the most from locations nearer to export hubs and can be key targets when seeking out potential tenants.
Advantages of Commercial Real Estate Investing
Generally, commercial real estate is sought after for its higher rental income and lower maintenance commitment. Giving the landlord a highly passive income with minimal work done – especially when the lease term is for a longer period than the typical residential lease.
Here are some of the key advantages of investing in commercial real estate.
- Higher rental returns
- Less maintenance
- Business relationship
- Limited operating hours
- Flexibility in lease terms
1. Higher rental returns
Commercial real estate typically gives a higher rental return, with the rental yield at 6% – 10%, with the outlier being as high as 15%. In contrast to residential real estate, the typical rental yield is between 4% – 6%, with 8% being considered an outlier.
Personally, I have known of investors who own commercial real estate that has given them a 12% annual rental yield with a 5-year lease. In other words, you can potentially make a 60% return on the property in 5 years, a very lucrative deal indeed by all means. Furthermore, the potential capital gain on the property really sets it apart, making it a strong investment case against the typical residential real estate.
2. Less maintenance on the landlord
The burden on maintenance for the retail unit or any office space typically lies on the tenant itself. Due to the nature of how business is operated, most of the furnishing and renovation works are done by the tenant to achieve a desired aesthetic and hence, maintained by the business operator itself. This also frees the landlord from managing every leak and maintenance, transferring most responsibilities to the tenant.
However, landlords of commercial real estate buildings, such as shopping malls or retail building, is still responsible for the upkeeping of the common facilities. Maintenance of the common spaces and shared facilities is very much the responsibility of the landlord.
3. Business relationship between business owner and landlord
Commercial real estate leasing paperwork is typically done between 2 limited liability companies (LLC). Due to the business nature of CRE, commercial properties are not commonly held directly by the investor but through an LLC to safeguard the investor against unwarranted lawsuits.
As such, the relationship between landlords and tenants is professional and courteous.
4. Limited operating hours
One of the many unexpected pains of residential property landlords is the random hours a tenant calling you to complain of a broken pipe or leak in their unit. Such is the nature of a business-to-consumer relationship, common for residential rental properties. With individual families being home only after a long day of work, it is common to receive complaints late into the evening, in some extreme cases, in the middle of the night.
On the contrary, the relationship nature of commercial real estate lease is between 2 business entities, professional and courteous. Hence, most maintenance issues are lodge during the day when the business is in full swing and the landlord is given sufficient notice to make plans for maintenance work.
The ability to plan for maintenance if taken advantage of will give CRE landlords more freedom to manage their time effectively.
5. Flexibility in lease terms
The tenancy agreement for residential properties is fairly standard with the regular clauses to safeguard both landlords and tenants. Typically, it includes a 1-year commitment with a 1-year renewable option, together with a 2.5 months deposit to cover rental and utility security.
The same cannot be said for the commercial property lease terms. There are fewer consumer protection laws to govern commercial leases, unlike those in place to safeguard the residential tenants – deposit limits and tenancy termination rules. There are primarily 4 types of commercial property leases, each requiring a different level of responsibilities from the landlord and the tenant.
- Gross Lease – Tenants are responsible only for the rent; Landlords are responsible for the property tax, insurance and maintenance
- Single Net Lease – Tenants are responsible for the property tax
- Double Net Lease – Tenants are responsible for the property tax and insurance
- Triple Net Lease – Tenants are responsible for the property tax, insurance and maintenance
Depending on the nature of business, certain business entities will choose to go for either the double net lease or triple net lease to maintain a corporate look and branding. Triple net leases will provide tenants control over maintenance for branding purposes while landlords get to enjoy the lower maintenance cost.
Disadvantages of Commercial Real Estate Investing
Commercial real estate main disadvantage is the high capital upfront needed to fund the purchase. Besides that, it is highly cyclic and dependent on the current economic status. A weakness in the retail industry can drive the value of commercial real estate down while a healthy economy introduces strong demand for retail properties.
Below are key disadvantages to consider before delving further into commercial real estate investing,
- Higher initial outlay and property tax
- Higher time commitment
- Economy cycles
- Unforeseen risk – Sales and Purchase agreement, tenancy agreement
1. Higher initial outlay and property tax
When it comes to commercial properties, the maximum loan a commercial property purchaser can get is up to 85%, with most commercial loan margins at 80%. This will require investors to fork out a higher initial capital to purchase the property. In most cases, investors are required to fork out up to 25% of the purchase price to cover the down payment and the necessary legal fees.
Unlike residential properties, the highest margin of finance is 90% for the first and second residential properties. On top of that, it is also common practice now for developers to give high rebates – zero down on residential properties. Hence, residential property investors do not need to fork out as much capital for the initial outlay.
At the same time, property taxes such as quit rent and assessment taxes are higher for commercial properties at 10%. Residential properties have a lower assessment rate at 4% – 7%.
In my opinion, the higher upfront capital is worth the investment when it comes to commercial real estate; provided all the necessary work were done beforehand with realistic simulation to understand the risk to reward portfolio covering the worst possible outcome.
2. Higher time commitment
Time commitment from the landlords varies between the different commercial property categories. For landlords owning commercial buildings such as a retail lot, the time commitment is much higher than a retail unit. Landlords for commercial buildings are expected to pay more attention and effort to maintain the common facilities whereas retail units do not have common space that requires the landlord’s attention.
This includes the maintenance of common facilities, such as elevators, roadside curbs and also landscaping.
If the business revenue justifies the hiring of a team of professionals, it is better to have a property manager and a team of maintenance workers to run the show for you.
3. Economy cycles
Commercial real estate is highly influenced by economic cycles and on some occasions, investors might be required to fork out of their own savings to pay monthly mortgage instalments. Taking an example of the COVID-19 pandemic, the economy has seen many businesses filing for chapter 11, shrinking their workforces and some terminating their long term leases.
At the same time, we also saw a significant dip in demand for office spaces and retail lots, leaving many commercial property investors bleeding out of their pockets or defaulting on their mortgages.
Hence, successful commercial property investors that I know have cash buffer enough to sustain 6 months to a year of economic recession. In some cases, 2 years of cash buffer will be a fairly conservative measure.
Additionally, knowing specific indicators of various market cycles will help you determine the opportunities present right now and to make informed decisions.
4. Unforeseen risk – SPA agreement and Tenancy agreement
Unlike residential properties, sales and purchase agreements for commercial properties are not governed by HDA. If you are buying a commercial property off-plan from a developer, it is ideal to have your own lawyer advise you on the terms and conditions.
At the same time, commercial property developers can be notoriously known for defaulting on commercial projects. In the past property boom, we saw many startup property developers defaulting on their projects, vanishing with the purchasers’ money. This left many investors helpless with no recourse against the developers
While it is not as common today, we still have such instances happening from time to time. Hence, it is better to purchase commercial properties from reputable developers who have consistent delivered on their promises.
Investing in Commercial Real Estates
Investing in commercial real estate is lucrative and can serve as hedging against inflation. Here are some ideas on how aspiring investors can get their feet wet in commercial real estate investment.
- Direct investment – sole ownership
Wealthy investors can choose to invest directly into the commercial real estate as the sole owner. If managed properly, the high cost of investment can provide substantial returns for the sole ownership.
Sole ownership also provide the investor absolute control over maintenance and tenant management. - Group investment – partnership / group purchase
Like-minded investors can also choose to pool together their fund to own a commercial real estate. This is typically done through fractional ownership with multiple purchasers having different stake to the LCC holding the commercial property.
Returns and capital gains are paid out in accordance to the shareholding percentage for each investors. - Real Estate Investment Trust, REITs
This is an indirect way to diversify into commercial real estate. It is equivalent to buying shares of a corporation that owns the real estate. As an investor, you benefit from dividends and capital gains matching the desired industry.
Unlike group investment, REITs investors do not own any of the physical property and have no control over the tenant management. If the investment does not go in your favour, the only option for REITs investor is to withdraw from the funds completely.
Final Word
Commercial real estate investing can be a good alternative to residential real estate for investors with more capital and a higher risk appetite. When deciding if commercial properties suit your investment portfolio, it is important to practice a good level of scepticism when projecting for potential returns.
Not everyone has the same risk appetite and patience to see through a long term investment such as commercial real estate. Hence, it is important to understand first your personal needs, appetite and timing before delving deep into the commercial real estate market.
Until then, take care.
