Property investment: commercial or residential?
One need only glance at a newspaper to realise how far the limbs of Australia’s property market reach across the country’s economic and cultural landscape.
Everyone from your solicitor to your barista has an opinion on where prices are going, and it’s rare to attend a family BBQ or dinner without broaching the topic on at least one occasion.
It’s a completely different story, however, when the conversation shifts towards commercial property. Ask a random passerby what they know about this half of the market and you’re likely to be met with little more than a scratch of the head. Which is a shame, because the commercial property market is full of opportunities and typically promises greater returns.
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With that in mind, here’s our guide to the differences between commercial and residential property.
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. The upside, however, is that they also offer greater returns.
Here are the main ways these property types differ.
- 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.
- 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.
- 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.
- 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.
- 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).
- 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.
- 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.
- Terms of finance – because commercial investment is deemed higher risk than residential investment, 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.
- 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.
- 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.
- 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.
Which offers the higher rental yields: commercial or residential investment?
Commercial properties offer rental yields in the region of 5% – 12%, whereas residential properties tend to deliver yields somewhere between 3 and 4%. This is because commercial properties need to offer high enough yields to encourage investors to willingly take on the higher risks.
Is commercial property more expensive than residential property?
This is a common misconception about commercial property investment. While high-rise offices and big-box retail units often sell for tens of millions, the commercial market arguably offers a wider range of price points.
You could buy a carpark for as little as $80,000, or a well-located office for roughly $400,000. Depending on the location, the same amount of money could buy you a three-bedroom home. But, assuming you found a reliable tenant, the office would likely offer you a much higher yield.
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.
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 property?
If you’re new to property investment, it’s probably best to buy a residential property first, as the associated risks and level of business knowledge required are much lower. On the other hand, if you’re an experienced investor with multiple residential properties in your current portfolio, investing in the commercial market would make sense, as you could improve your cash flow – thanks to higher rental yields – whilst diversifying your portfolio and reducing your exposure to downturns in the residential market.
Another reason why commercial investment is better suited to more experienced hands is because it requires deeper pockets. This is partly because the increased potential for extended vacancy periods means that investors need enough money to cover a property’s outgoings over a prolonged period of time, and partly because upgrades to commercial properties generally cost more than upgrades to residential ones.
Finally, the commercial property’s sector increased vulnerability to broader economic shocks means that commercial investors typically need stronger business acumen than their residential counterparts. Which is not to say that the commercial market is necessarily off-limits to mum and dad investors; rather, that those who’d like to take the plunge should seek advice from a team of professionals before doing so.