The Experts

Commercial vs. residential: what stacks up?

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With global investment markets starting to pick up and defensive assets such as cash and fixed interest struggling to perform as interest rates fall, growth sectors like property are becoming more attractive due to higher yields and their potential for capital growth. But with so many different property investment options should investors be looking more closely at commercial property or sticking with the more familiar residential?

As CEO of Centuria Property Funds, manager of $1.1 billion in property assets, I am often asked about the differences between commercial and residential property and which is most attractive right now. My answer is that, while both have their pros and cons, commercial property investments – that is, office, retail or industrial – currently offer particular appeal. There are a number of reasons for this.

First, there’s return. Returns from commercial compare very favourably with those from residential right now: typically in the order of 8-9% compared with a slim 2-4% from residential. 

Further, commercial tenants are also often more reliable in terms of ability to pay the rent. Consider a large successful company compared to, say, a group of university students and you get the point.  Having said that, it is important to bear in mind that choosing a reliable tenant for a commercial property isn’t always straightforward either. A rigorous vetting process, which in turn requires some expert property and financial knowledge, is required.

Surety of income is another good reason. Commercial tenants usually provide a bank guarantee of six to 12 months to secure their lease obligations.  Commercial lease terms – and thus certainty a property will remain tenanted and generating income – also tend to be much longer than those in residential properties, usually 3-10 years  with annual reviews of 3-5%. Residential leases are typically only six or 12 months with no set reviews.

Another major advantage of commercial over residential property is that tenants are responsible for all outgoings, including repairs and maintenance, land tax and property management fees. In residential properties, these costs are borne by the landlord and are deducted from their gross return.

Then there’s the question of debt. Commercial property tends to involve less debt than residential, as banks generally lend at a lower loan to valuation ratio (LVR) than for residential property. This is typically around 50%, compared with up to 95% for some residential property. Less debt to service means more income from rents.

When it comes to the pros of residential property, there are certainly some. It is generally more accessible to retail investors: a commercial property such as an office building not typically an affordable option for most individual retail investors. However, that’s where an investment vehicle such as an unlisted property fund can be an attractive option. Unlisted property funds enable investors to pool their money with other like-minded investors to access the benefits of larger commercial properties. 

However, a note of warning. If you do decide to consider investing in at a property fund, be sure to look carefully at the track record of its manager. Much of the ultimate success of an investment depends on the quality of the manager and its ability to invest wisely and manage the asset well.

Should you decide to take the plunge, when it comes to identifying and buying a commercial property, investors should take into account many of the same factors as when deciding to invest in a residential property.

Location, for example, remains key, but in the case of commercial property, rather than shops and schools factors to think about include the precinct in which it is located (for example, its position in the CBD for an office asset); the nature and number of surrounding properties; its proximity to transport links; its tenancy profile and the possibility of adding value through refurbishment.

The right manager can also help mitigate some of the perceived ‘negatives’ surrounding commercial property, including that it may have higher vacancy rates and lower capital growth than residential property. With the right investment decisions, this doesn’t need to be the case.

When you look at the facts as outlined above, it’s clear despite Australian investors’ love affair with residential property, there can be some strong advantages to on the commercial side. It all comes down to choosing the investment vehicle that suits you and, of course the right manager. If you get those two choices right, the rest should follow.

Published: Friday, May 31, 2013

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