We are often asked whether it is better to invest in residential or commercial property. While we understandably are passionate about commercial property, we do our best to give our clients (including prospective clients) well-reasoned, sound advice, not poor, self-serving advice.
Everyone’s circumstances are different and there is no one-size-fits-all policy when it comes to investing in property. The best advice we can offer, and if you’re reading this blog, we can expect you have some interest in investing your money somewhere, is to invest as early as you can afford. There are myriad opportunities for where you can invest your money, but here we will focus on property, and specifically compare investment in residential vs. commercial property.
Hopefully some of our advice will help you on your investment journey.
Why Do People Invest in Commercial Over Residential?
Most commonly, people invest in commercial property over residential property because it provides a better return on their investment. As we’ll cover later in this blog, commercial properties are known for their better returns, hence they make a more attractive investment offering. There are some potential barriers to investing in commercial property, instead of residential property, such as a higher deposit being needed to purchase the property, but we will cover more of these factors later in this blog.
Most investors are looking for a good return on the money they invest, hence the attraction to commercial property. A lot of investors are happy to forego the better return from a commercial property and, instead, invest in residential property, hoping to benefit from capital growth in place of getting a positive return. While time may allow an investor to pay down their loan on a residential investment property and as the rent increases the property becomes positively geared, but getting positively geared residential properties (unless investing in remote / regional areas) is uncommon.
It is a common belief that the trade off for a positive return from a commercial investment property is that you forego the benefit of capital growth. While not all commercial properties experience good capital growth, many properties and market segments achieve great capital growth. Much like with residential property, not everyone is a winner. However, whether you’re investing in commercial or residential property, if your strategy is long term investment and not trying to play a short game and bank on quick market growth, you will almost always be rewarded (there’s always an exception to the rule).
Comparison of Typical Yields
Here, we will analyse what yields are being achieved in the local and broader markets for residential and commercial properties. Happily, as the residential property market is magnitudes larger than the commercial market, the published data is a lot more common and a lot more regular. This gives us a great and easily accessible snapshot of current yields for residential investment properties on the Central Coast, as well as the broader Sydney market (for a comparison to a capital city).
The commercial investment market does not attract as much independent research, analysis and reporting, unfortunately, so what data is available is usually either outdated or anecdotal. Happily, as we are commercial property specialists on the Central Coast, we have direct data to show what rates (yields) are being achieved for commercial property. We have industry reporting (though, admittedly from a few months ago, so the data is not as current as the residential data shown) to show what yields are being (recently) achieved in the Sydney market for commercial investment property.
As of this writing, the latest data is showing residential investment property yields for houses and units averaging 2.6% and 4.1% respectively. It is VERY important to note that these reported yields are GROSS yields, not NET yields. On the Central Coast, yields for houses and units are currently averaging 2.9% and 4% respectively. Again, reported as gross yields.
Outgoings for such properties usually include Council Rates, Water Rates, Building Insurance and Management Fees (assuming you engage an agent to manage the property on your behalf). If the property is strata title, then you will be paying Strata Levies, too (though likely not building insurance). These costs will further dilute that gross yield (mentioned above) by 1% to 1.5%, if not more, leaving you with a 1% to maybe 3% net yield.
Commercial properties, as we’ve already stated, most often provide a much better return on your investment. In the core Sydney market, recent investment yields for commercial properties have ranged from 3.5% net to 5% net, depending on the market segment and quality of the asset.
On the Central Coast, we are seeing yields range from 5% net to 7% net for commercial investment properties, again varying based on the market segment and quality of the individual asset.
The industrial market continues to be the strongest performer in the broader commercial market, seeing the most demand from buyers, so it is not surprising that it is achieving yields on the lower to mid end of the above range with the office market seeing returns on the mid to upper range above.
Risk vs. Rewards
Let’s start with some risks. Residentially, if you get stuck with a bad tenant, they can be very, very difficult to get out of your property and they may do a lot of damage that could leave you badly out of pocket.
Of course, tenant’s in commercial property can also do a lot of damage , though typically there is less damage they can do, and bonds for commercial tenants are also higher than for residential tenants. A residential bond cannot be more than four (4) weeks rent, whereas it is common practice for a commercial bond to be at least two (2), if not three (3) months rent (and sometimes greater, still).
If you have a delinquent commercial tenant, the process for evicting them from your property, so long as the process is followed properly, is far simpler than for a residential tenant. Commercial tenants are afforded far fewer legal protections, as they don’t come under the same consumer laws. This isn’t to say that commercial tenants don’t have rights. They do. Simply, this is just a more balanced playing field between landlord and tenant.
The greater risk that commercial investment property generally poses, compared with residential property, is that the vacancy periods tend to be longer (at times, much longer). Right now, we have some of the lowest industrial vacancy rates we have ever seen, so that concern is of little consequence. The commercial (office) and retail markets are less buoyant, however, so do present a higher risk. This risk is offset, in the opinion of most investors, by the superior returns achieved from commercial investment properties.
As we have already identified, commercial yields are typically far better than residential yields. The common practice of negotiating net leases, whereby it is negotiated that the tenant pays all the property outgoings, also makes commercial property an attractive option, as it means you won’t have the impact of fluctuating outgoings costs reducing your net rental return.
So Why Don’t More People Invest in Commercial Property?
There are some common reasons that people don’t invest in commercial property. One common reason is that there is a simple lack of understanding of how commercial property works.
This may be a lack of understanding about the types of commercial property (industrial, commercial or office, retail, bulky goods, etc.), the costs of ownership, how to structure commercial leases, the rights and obligations of commercial landlords, what vacancy periods to expect and what returns may be achievable.
In short, if you haven’t done it before, there can be a steep learning curve. This lack of understanding, or uncertainty, can create the perception of risk, and most of us are risk averse. While we like the idea of creating wealth for ourselves, our fear of the unknown is a greater force, so it proves to be a barrier for many of us (in many areas of life, not just investing).
For those of us who understand and are comfortable with these risks, the next most common barrier is money. More specifically, deposit money. Traditionally, financial institutions want borrowers to put up around 35% of the purchase price so they (the bank) are only lending 65% of the property’s value, keeping their own risk relatively low. Depending on the value of the property you are buying, 35% can be a pretty large sum of money and not easy for many of us to save from ordinary earnings.
There are other options to help overcome this issue, such as accessing equity from another property you own, such as your primary residence, but this naturally relies on you, firstly, owning another property and, secondly, having sufficient equity available.
Understanding your options and financial position is the best place to start if you’re interested in investing. We recommend you engage with your financial professionals, including your accountant, bank manager or commercial finance broker, and wealth management advisor, in order to discuss and assess how a potential investment fits into your overall plans.
We work with some great local people in these fields, so we’re happy to assist with some recommendations should you need them. We do not have any financial referral relationships, so any professionals we recommend is based solely on our belief in their abilities.
We always recommend making sure you’re comfortable with the person whose advice you’re taking, so ask them plenty of questions and leave no stone unturned and nothing to assumption. It’s your money, after all, so it’s your responsibility to ensure it is managed well.
