Complete guide to commercial vs residential property investment
Purchasing a commercial investment doesn’t have to be daunting or a financial frustration.
As well as being cheaper than some might think, commercial properties’ capital growth and rental yields can surpass that of their residential counterparts even during global pandemics.
Longer leases, less administration and limited outgoings are also a bonus.
Industry experts explain.
What is the difference between commercial and residential property?
The main difference between these two types of properties is that commercial properties are used primarily for business purposes and residential properties are used as homes. Consequently, commercial properties are more vulnerable to economic shocks than residential properties and are, therefore, considered higher-risk investments.
Purchasing a commercial property doesn’t have to be daunting. Picture: Getty
The upside, however, is that they also offer greater returns.
Here are the main ways these property types differ.
1. Lease length
Typically categorised as either office, retail or industrial, commercial properties have much longer leases than residential properties, and these leases play a crucial role in determining their value. This is because it’s much harder to replace a commercial tenant than a residential one, as commercial properties are more vulnerable to economic shocks than residential properties.
2. Vacancy periods
A combination of factors mean that vacancy periods in the commercial market tend to be much longer than vacancy periods in the residential market. This means that commercial investors will often have to cover a property’s outgoings without the support of rental income.
3. Lease terms
While there’s little variation between residential leases, the difference between commercial leases can be huge, with pretty much every term up for negotiation. Consequently, commercial investors have to work very closely with lawyers and financial advisors when drawing up a lease.
4. Rental yields
Commercial properties typically offer rental yields between 5% and 12%, whereas residential properties typically offer around 3-4% yields. As a result, commercial investments are more likely to be cash-flow positive than their residential counterparts.
5. Annual rent increases
Unlike residential leases, most commercial leases include fixed annual rent increases. These typically fall within the range of 3-4%, which is higher than the current level of inflation (1.8% in the 12 months leading up to December 2018).
6. Maintenance and repairs
In the world of commercial property, it’s more common for tenants to sign net leases than gross leases. This means that they are responsible for paying council rates, insurance, land tax, maintenance and repairs. Meanwhile, in the residential market, these expenses are billed to the landlord, which is yet another reason why it’s more common for commercial properties to deliver a positive cash flow. Commercial investors, however, are required to weigh up this benefit against the higher cost of repairs more broadly. Combined with the increased potential for extended vacancy periods, the higher cost of upgrading a commercial property means that commercial investors generally need to have access to more readily available capital.
7. Tenant behaviour
That commercial tenants use their rented premises to run a business means they have a stronger incentive to take care of the property.
8. Terms of finance
Commercial investment is deemed higher risk than residential investment, hence banks generally require a minimum deposit of 30% for commercial properties but often lend to residential investors with smaller deposits. What’s more, commercial loans generally attract higher interest rates and administrative fees.
9. Exposure to economic shocks
While people always need a place to live, demand for a business’s goods and services ebbs and flows, which means that demand for commercial property is more elastic than demand for residential property.
10. Knowledge required
Commercial investors need to have a deeper understanding of the broader economy than residential investors, because demand for commercial properties is more sensitive to economic shocks. This means commercial investors generally need to conduct more research before buying a property.
11. Capital growth
While this point is fairly divisive, the majority argue that commercial properties experience slower rates of capital growth than residential properties. Which is another reason why the lease and tenant are of paramount importance to a commercial property’s value.
Is commercial property more expensive than residential property?
Carparks can be purchased with very few funds. Picture: Getty
Commercial property doesn’t have to be more expensive than its residential counterpart with carparks being a prime example of this point with some available from just $20,000 while a Gold Coast buyer recently purchased a 21sqm lockup garage for just $110,000.
Offices and retail assets can also be purchased for as much as, or less, than a residential unit.
However, Mr Boulden believes at least $1 million is needed to buy a commercial property with a decent income.
“You may see properties available for $600,000-$100,000 but they generally only have a short term tenant and it will be a strata-type office where the tenants are on a one year term,” he said.
“So, you might get an income but there’s no guarantee or security beyond what those terms look and there’s the ongoing management of the asset.”
How do you work out a commercial property’s value?
Because commercial properties tend to experience less capital growth than residential properties, the most effective way of determining the value of a commercial property is by basing your calculations on its rental income – namely, by dividing the property’s current rental income by the average rental yield offered by similar properties to the one you’d like to buy.
For example, let’s say you’re interested in buying a 125 sqm shop that’s currently leased for $50,000 net per annum. After analysing similar properties in the local market, you determine an acceptable yield is 8%.
This would mean the property would be worth = $50,000 ÷ 8% = $625,000.
This is very different to how a residential property is valued. Because a lot of a residential property’s value is tied up in its potential for capital growth, and because owner occupiers are often as interested in buying a residential property as residential investors, much less attention is paid to the lease and tenant when determining the value of a residential property.
What is the difference between a commercial and residential property mortgage?
To buy a commercial property, you’ll need to apply for a business loan, rather than a standard home loan, and you’ll likely need to provide a business plan and profit forecasts to secure one.
There are some other differences between commercial and residential loans. You’ll need to save a larger deposit for commercial properties, too – typically a minimum of 30% of the property’s lender-assessed value – and pay higher interest rates and administrative fees on these loans, as the banks generally consider them higher risk.
Should I invest in commercial or residential in the post-COVID market?
Both Mr Boulden and Mr Weir point to residential properties, rather than commercial as having the better prospects in a post-COVID world.
“Commercial properties have seen a lot of capital growth in the past 12 months in particular, due to investment yields tightening,” Mr Weir explained.
“Commercial yields have also probably dropped by at least 75-100 basis points in the past 12 months for most asset classes, which is quite a large drop in a short period of time.
“It’s unlikely that these yields will drop down anymore especially if interest rates start moving up the other way so I think the prospect of capital gains for commercial properties are diminishing.
”There’s still good commercial properties out there but your growth in value is more likely to come from, or will be reliant, upon rental growth not capital value growth.”
Mr Boulden concurred saying he knew of many commercial real estate agents who were buying residential properties as investments.
“This is purely because residential offers a guaranteed income and whilst that return might not be as strong as commercial, it is consistent, plus there’s capital growth there as well,” he said.
“Certainly if somebody gave me a few million dollars, I’d probably diversify and get a combination of both residential and commercial.
Mr Boulden added that residential properties were currently also enjoying very high demand, particularly those in the rental market.
“So, I think we’ll see investors starting to push into this market a bit more, although they’ve been largely absent for a number of years,” he said.
-with reporting from Euan Black
