Residential vs Commercial Investment: Key Differences Every Investor Should Know

When starting out as a first time investor, the choice between residential and commercial can seem overwhelming. Most investors will be more familiar with residential, but could they be getting a better return on their investment using commercial property? If so, what type of commercial property is the best option?

There are all sorts of things to consider along the way, such as: price point and loan to value ratio; rental yields; total returns; ease of management; market volatility; tax benefits; investor profile and market conditions and trends. This article will define these terms in turn and discuss the various pros and cons of both types of property.

Residential vs Commercial

What do we mean by residential and commercial real estate? Residential includes detached houses, semi-detached townhouses and apartments. Commercial property is much broader and includes traditional categories such as office space, retail shops and industrial warehouses, along with alternative classes such as childcare centres, medical clinics, aged care facilities, motels, hotels, veterinary clinics and so on.

Price Point and LVRs

So, when should an investor consider one category over the other? It depends on the budget to a large degree. More than likely, a loan will be required for the first investment. Banks will want to see the borrower has enough experience to mitigate any downside risks from their perspective, such as defaulting on loan repayments. So price point and loan to value ratios are key requirements to consider as these parameters affect loan serviceability.

Residential property has lower price points or entry costs, typically anywhere from $300,000 to $1,500,000. Access to finance is favourable at this level; deposit rates range from 5% to 20%. Put another way, the Loan to Value Ratios (LVRs) are generous, ranging from 80% to 95%, illustrating the confidence banks have in the residential market on a macro level.

By comparison, commercial property has a higher entry point, with price points typically from $1,000,000 to $5,000,000 for a first time commercial property. Banks are more cautious however, and require deposits of 30% to 50%. Alternatively, commercial LVRs are much lower, usually between 50% and 70%, which reflects the higher volatility associated with commercial property.

Rental Yields and Returns

Rental yield is the measurement of the annual rent and the purchase price expressed as a percentage. It can be expressed in net terms or gross, which means excluding or including outgoings respectively. Outgoings are any costs associated with property ownership, such as council rates, insurance, land tax, repairs and maintenance, body corporate rates and so on. Any prudent investor will evaluate a property on a net basis to make comparison between properties easier. However realtors don’t always provide the net return, instead presenting the gross income. In these cases a quick ‘rule of thumb’ is a 20% allocation of gross rent to outgoings. It is best practice to determine the actual outgoings before finalising any purchase.

Residential yields are typically 3-5% net per annum. By comparison commercial real estate usually returns from 5-8% net per annum, or more. The variation in rental yields reflects the lower risk profile of residential compared to commercial.

Another way of thinking about rental yield is as an income return. This term is useful as it distinguishes between capital return, or capital growth, which is how much the asset increases in value over time. The income return plus the capital growth is known as the Total Return. Some first time investors mistakenly become fixated on income return. However the more prudent approach is to consider the potential for capital growth primarily, assuming the basic requirement for loan servicing has been met. Optimising for capital growth will often lead to superior Total Returns over the medium to long term, regardless of real estate type.

It is worth noting that residential property relies on capital growth to fuel Total Returns, as opposed to the income return. Rental lease terms are typically 6-12 months, so rental rates are regularly adjusted to market levels. By comparison, commercial property typically has longer lease terms, say from 3 to 10 years, which can include built-in rental increases. As a result, commercial property has the potential to benefit from superior rental returns and higher total returns.

Tenant Management

Tenant management is a major difference between residential and commercial property. As alluded to above, with 6-12 month lease terms residential property has higher tenant turnover compared to commercial. This gives rise to the potential for higher vacancy rates and the attendant costs, such as lost rental income, agency leasing fees and advertising expenses, diminishing total returns. Residential property also has a higher likelihood of missed rental payments and tenant disputes and the need for tenant insurance. Additionally, landlords are responsible for outgoings, meaning the prospect of ongoing out-of-pocket expenses.

Tenant management is much less involved with commercial property. With longer lease terms, typically three to ten years, or more, tenant turnover is much lower. The lease terms often include an “Option Period” which gives the tenant the right to a further lease term upon lease expiry. For example, a commercial property may be advertised with a lease term of “5+5 with annual CPI rental increases and Market Review at option with a ratchet”. What this means is that the initial lease term is five years, plus the tenant has the option of a further five year term, with the same conditions as the original lease, aside from the rent. The rental amount is increased each year of the initial term by CPI, and is renegotiated at market rates upon the expiry of the first five year term, with one restriction: the rent cannot be less than in the previous year.

Furthermore, commercial leases almost invariably place the responsibility for outgoings, including repairs and maintenance, on the tenant. This covenant structure is known as a ‘net lease’. For this reason commercial property is often described as ‘set and forget’, which is why many passive property investors prefer this category over residential. There are varying degrees to which the tenant is responsible for outgoings. The highest standard is known as a ‘Triple Net Lease’, which is when the tenant pays for all outgoings, including land tax. As these types of covenants are more desirable from a buyers’ perspective, the yields for such assets tend to be towards the lower end of the commercial yield spectrum, say 5% to 6%.

Commercial leases can be negotiated on a gross basis. This occurs in markets where the tenant has the upper hand in negotiating, say in an over-supplied market, and means the landlord pays for all outgoings. To compensate for that, the rental is increased in proportion to these costs. There are variations of this lease structure where the landlord and tenant agree to share the burden of outgoing expenses, known as a semi-gross lease.

Market Volatility and Risk

As stated earlier, residential property is deemed to be lower risk by the banks, which is due to the consistent under-supply of housing in Australia. That means the chances of the property remaining vacant for an extended period are very low, assuming it has been adequately maintained. Furthermore, residential property is less prone to economic cycles compared to commercial.

By contrast, commercial property is more prone to economic fluctuations, particularly changes to the cash rate over time. Investors think about commercial property investment returns in terms of the ‘hurdle rate’, which is the return above the ‘risk free rate’, or the 10 year bond rate. The latter is closely linked to the cash rate, so should a material change in cash rates eventuate, commercial investment hurdle rates will also be affected. An investor ought to be compensated for risking capital in commercial property rather than investing it in the bond market. Say for example the risk free rate is 4.50% and the hurdle rate is 150 basis points, the required commercial net yield would then be 6.00%.

Commercial property is more prone to industry shifts. The most recent example is the commercial office market, particularly secondary grade CBD assets. The Covid Pandemic of 2021 gave rise to a material decline in demand for commercial office space as working from home became necessary during lockdowns, and normalised once the crisis was over. Firms were forced to implement costly IT infrastructure upgrades to accommodate remote working during lockdowns. These costs and the new flexibility the installations allowed caused many firms to rethink their space requirements, often downsizing considerably in the post Covid era. Vacancy rates in some commercial office markets remain in the high teens, indicative of recession like conditions. In these conditions prolonged vacancy periods of 6 to 9 months are common.

Retail commercial property too has been exposed to a structural decline in demand as consumers increasingly opt to buy online. In this case the trend has been slowly increasing over time, gradually eroding retail returns, albeit punctuated with key market events, such as the Lowey’s sale of Westfield in 2017 and Amazon’s entry into the Australian market. Amazon has entered the grocery market in Australia and has invested heavily in super-sized automated warehouses that offer extremely efficient delivery timeframes, often less than 24 hours.

Tax Benefits and Incentives

Both residential and commercial property allow for depreciation benefits for taxation minimisation purposes. However commercial property provides for higher allowances and includes major capital expenditure for items such as fitouts and equipment. In addition, commercial property requires careful consideration regarding GST implications, particularly around purchases and rent. This often necessitates professional advice.

Residential property investment is well suited to high income earners as it allows for ‘negative gearing’. This strategy runs a property investment as a cashflow loss, claiming that loss as a tax deduction. The approach can work if the property has been carefully selected to optimise for capital growth, however is a dubious approach otherwise.

Residential property also allows for capital gains tax concessions, whereas commercial property does not. While this does give residential investors more flexibility, CGT liabilities are significant costs to consider. This explains the popularity of the ‘buy and hold’ approach, for both residential and commercial property, whereby the owner uses accumulated equity as collateral for future acquisitions instead of selling one asset to purchase another.

Liquidity and Exit Strategies

Residential property is inherently more liquid than commercial due to the deeper pool of potential buyers. These buyers could be either owner occupiers or investors. However in the case of commercial property, the buyer pool is much smaller, and quite selective about purchases. For this reason, commercial property investment requires careful consideration of the ‘exit strategy’.

The ‘exit strategy’ addresses the question of when does the investor sell, and under what circumstances? Commercial property investors are highly attuned to cash flow risk and seek to reduce such risks as much as possible. Consideration is given to lease duration and terms, particularly the inclusion of options, covenant strength and supply and demand for similar properties.

Covenant strength refers to the reliability of the tenant. Is it a new entrant to the market, say ABC Hardware, or is it a trusted name such as Bunnings? Is it a state based, national, or international brand? Investors will pay significantly lower or ‘tighter’ or ‘sharper’ yields for trusted brands. For example, McDonalds restaurants often trade below 5% net yields.

What does this mean for the exit strategy? For commercial property it is best to sell with a new lease in place with a quality tenant, or at least a reasonable term remaining on the original lease. For example, say the investor owns a property with a 10+10 year lease to a national brand and is considering selling in year nine of the first term. Would that be a good idea? Perhaps not. From an incoming investor’s perspective they only have one year of secure income and a sitting tenant who may or may not exercise their option. Wouldn’t it be better to wait until the tenant commits to the second term and then sell? That approach mitigates income risk for prospective investors and will result in more competition for the asset.

Residential exit strategies look much different. It may be best to sell the property with an expired, or ‘month to month’ lease in place, or with ‘vacant possession’, rather than a new lease. The reason is that the potential pool of owner occupiers usually outweighs property investors, although that will depend on economic conditions at the time. So for example if a residential investor has an asset with six months remaining on a 12 month lease, should they sell it now or wait for it to expire? The answer will depend on their personal circumstances, however assuming they are under no compulsion to sell, the better option would be to wait. Otherwise the larger pool of potential owner occupier buyers will overlook the asset, leaving the vendor with only other investors to sell to.

Location & Land Content

Why is location so important? To answer this question it helps to take a step back and consider what an investor is really buying. At the core of any property investment is the land. Land scarcity is what ultimately drives capital growth, so it is critical to think about the allotment itself first and foremost. Is the shape amenable to efficient use? Does the zoning allow for the current or planned use? Is the location and surrounding development supportive of capital growth?

In the case of residential property, this usually means proximity to lifestyle / family amenities, such as beaches, waterfront, parks, work nodes, schools, transport, gyms, cafes, restaurants and cinemas. It should come as no surprise that suburbs such as Bondi Beach and Manly in Sydney are very expensive. Both are within 10 km of Sydney CBD with easy access to beaches and cafes, meaning demand for accommodation far exceeds supply. The same could be said for Sydney’s Eastern Suburbs more broadly.

Should an investor consider a residential apartment? It depends on the ‘land content’. While apartments are more affordable than detached housing, the land content is inherently diluted compared to detached housing. The nature of strata title is also far less appealing with regards to future renovations, alterations and so on, not to mention the burden of strata fees. Do these factors preclude apartments altogether? Not necessarily. An older style, low-rise block of, say, six apartments on a good street has a higher land content than a taller building with more apartments. The scarcity factor is therefore higher and will likely give rise to superior capital growth relative to a medium or high density equivalent.

The availability of scenic views is another factor, but prudent buyers also consider how secure are those views?. Could they be ‘built out’? What is the zoning of the land between the property and the view? Could someone build a taller building and block the view? Could the owner object to such plans and how would the Land and Environment Court rule on that based on case law?

Commercial property investors are more interested in how the property supports the business. A warehouse owner will consider truck access, hard stand parking, fire safety, proximity to both major transport hubs and infrastructure, such as ports. They would also consider the office to warehouse ratio. Is it too high? Would that create an issue when it comes time to lease or sell?

It’s slightly different for retail property. A retail property investor would be interested in foot traffic and exposure, or external visual lines of sight. How much passing trade is available in the location? What future development may affect that, if so, how? What does the zoning allow for? Are there any changes afoot? How could that help inform an ‘exit strategy’? Is the current use the ‘highest and best use’? How might that change over the investment period?

Financing and Lending Differences

Lending criteria are quite different for commercial compared to residential properties. The main difference is loan term, which tends to medium term, say five to ten years, versus long term for residential, say 30 years. As alluded to previously, banks consider residential property less risky than commercial property, which is reflected in higher interest rates for commercial property. Banks also require higher LVRs, usually 50%, meaning the investor must have a larger deposit to complete the purchase.

The additional risk and complexity of commercial results in higher valuation fees. A commercial property valuer will produce a 20 to 30 page report covering economic conditions, a detailed summary of the zoning and planning instruments, recent market evidence, valuation rationale, caveats and conclusion. The analytics may include a Discounted Cashflow Analysis (DCF), which is usually done with specialised software, alongside traditional approaches such as Direct Comparison and the Capitalisation Method. The costs of such advice are usually in the thousands.

By comparison, residential valuations are much simpler, largely relying on the Direct Comparison Method. Residential valuations are increasingly being done ‘in-house’ by the large banks using automated models to emulate the traditional ‘Direct Comparison’ approach used by a valuer. The costs are therefore much lower, usually a few hundred dollars.

Investor Profiles and Goals

Which is best for a first-time investor, residential or commercial? Assuming the investor is borrowing money to fund the acquisition, we also need to consider the banks’ likely position on this question too. The banks will definitely favour residential over commercial for a first-time investor. Why is that the case though, more specifically?

The banks know that residential property is structurally under-supplied in Australia. That means there is likely to be stable demand for residential property over the term of the loan, leading to little price variation, and ultimately, little prospect of the bank losing money. Basically, unless the investor is using cash, residential may be the only option. That means the strategy ought to be a long-term investment optimising for capital growth, as the income return will be lower relative to commercial.

The other factor to consider is that investors inherently know more about residential property than commercial. Everyone has accumulated knowledge about residential property just by the mere fact of living in Australia, even if they don’t realise that knowledge can be applied to investment due diligence. In order to do so, the question becomes: ‘would I want to live here?’, or ‘who would want to live here?’ as a useful starting point.

Perhaps the best attribute of residential property investment is the leverage available. Banks will loan 90%, or more in some cases, compared to only 50% to 70% for commercial property. That means an investor would only need a deposit of $50,000 for a $500,000 residential investment, as opposed to up to $250,000 for an equivalent commercial investment. How long would it take to save an extra $200,000 to buy the commercial property? Would that be a good strategy? What about the opportunity cost of attempting this?

Some first-time investors may be in a financial position to buy commercial property. Should they? After all, the yields are better, as discussed earlier. That would make sense if they had detailed knowledge of a particular asset class, say industrial, and could use that to inform investment decisions. Otherwise it might be more prudent to consider a residential investment instead, with a view to building more equity in the medium term before acquiring a commercial property.

Summary

We have discussed many considerations above, and it is clear that residential and commercial property are very different and both have a place in many investors portfolios. How those differences play out in each investor’s situation will depend on the investors unique personal circumstances.

If you're unsure which path is right for you, our expert team can guide you through tailored property strategies. Book a free consultation to dicuss more