A guide to commercial vs residential property investment By Your Investment Property
What’s the difference between commercial and residential property?
Australia’s residential property market is a hot topic: everyone from your solicitor to your barista has an opinion on it.
Commercial property, on the other hand, is a different story. Yet the commercial market is full of opportunities, and typically promises greater returns.
1. Lease length
Commercial properties have much longer leases than residential properties, and it’s much harder to replace a commercial tenant than a residential one. This plays a crucial role in commercial property valuations.
2. Vacancy periods
Since it’s difficult to replace commercial tenants, commercial vacancy periods tend to be longer than residential vacancies. Commercial investors often have to cover a property’s outgoings without rental income.
3. Lease terms
While there’s little variation between residential leases, commercial leases can vary wildly, with almost every term up for negotiation. Commercial investors draft leases with help from lawyers and financial advisors.
4. Rental yields
Commercial properties typically offer yields from 5-12%, compared with 3-4% for residential properties, so they’re more likely to be cash-flow positive.
5. Annual rent increases
Unlike residential leases, most commercial leases include fixed annual rent increases of between 3-4%, which can exceed the inflation rate.
6. Maintenance and repairs
Unlike residential tenants, commercial tenants more commonly sign net leases that make them responsible for paying council rates, insurance, land tax, maintenance and repairs. Of course, commercial investors face higher costs of repairs more broadly. Again, this means commercial investors usually need more available capital than residential investors.
7. Tenant behaviour
Since commercial tenants use their rented premises to run a business, they have a strong incentive to take care of the property.
8. Terms of finance
Commercial investment is deemed higher risk than residential investment, so banks generally require a minimum deposit of 30% for commercial properties — much more than a typical residential deposit. Commercial loans attract higher interest rates and administrative fees, too.
9. Exposure to economic shocks
Demand for a business’s goods and services ebbs and flows, so demand for commercial property is less consistent than for residential property.
10. Knowledge required
Commercial investors need to do more research, and have a deeper understanding of the economy, than residential investors because demand for commercial properties is more variable.
11. Capital growth
While this point is divisive, the majority argue that capital growth is slower for commercial properties than residential. That’s another reason why the lease and tenant are critical to a commercial property’s valuation.
Is commercial property more expensive?
No. The commercial market offers a wider range of price points than the residential market. You could buy a carpark for as little as $80,000, or a well-located office for $400,000 — as much as a typical three-bedroom home. But, with a reliable tenant, the office would likely deliver a much higher yield.
How do you value a commercial property?
The best way to determine the value of commercial property is to divide the property’s rental income by the average rental yield offered by similar properties.
For example, imagine you’re valuing a 125sqm shop that’s leased for $50,000 net per annum. Your research shows similar properties have a rental yield of 8%.
This means the property would be worth $50,000 ÷ 8% = $625,000.
How do you apply for a commercial property mortgage?
To buy a commercial property, you will need to apply for a business loan, and provide a business plan along with profit forecasts. The deposit will likely be at least 30% of the property’s lender-assessed value, and pay higher interest rates and administrative fees, too.
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 this doesn’t involve as much risk, or require as much knowledge.
But, if you’re an experienced investor with a portfolio of residential properties, a commercial investment may make sense. You’ll likely have the deeper pockets needed to get the most out of the investment. It could also improve your cash flow – thanks to higher rental yields – while reducing your exposure to residential market downturns.
This information is of a general nature and does not constitute professional advice. You should always seek professional advice in relation to your particular circumstances.
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