Going Commercial: Commercial Versus Residential Property

Posted by Luke Graham

Residential is Australia’s favourite property asset class, and the biggest characteristic of this is perhaps that most people have a better understanding of it due to their own experiences renting, owning or building their own homes. Demand would always exist in some form because we know from our beloved humanistic psychologist Abraham Maslow that a basic need of the human condition is shelter.

Commercial property is a different beast entirely. In fact, the similarities between residential and commercial property effectively expire after the following facts:

They are tangible assets, that is, they can be seen and touched, and
Cash flow is achieved through an entity ‘renting’ the asset as a tenant.

Since both residential and commercial property exist as investment products, it is clear that they both have merit. The question for the investor is which one suits their personal investment strategy the most, given their current portfolio composition, personal income, their financial goals, and of course their risk profile. Summarising the characteristics of these complex investment products is difficult in a short blog post, but some predominant points worth consideration are tabled below.

Residential Property

Capital growth is traditionally stimulated by emotive demand from owner occupiers, who compose about 70 per cent of the purchaser market. Standard rental yields are around 5 per cent per annum and fluctuate depending on recent capital growth and supply.

Vacancy rates are usually less volatile, reflecting the ability to interchange tenants relatively easily in comparison to commercial property. Banks will lend a higher percentage of the property’s value, immediately indicating a perception of a much lower risk premium for residential and allowing the investor more flexibility with leverage.

Commercial Property

Seeks both cash flow from rent and capital growth, both of which are traditionally stimulated by the type of tenant, the lease agreement, the ‘highest and best use’, floor space (gross lettable area) and, on a higher level, consumer behaviour. Rental yields are traditionally much higher than residential property.

Vacancy rates are volatile and depend on a multitude of variables, including the use of the dwelling and its location. Banks lend at a more conservative loan to value ratio, reflective of a higher perceived risk, which results in less of an opportunity to leverage one’s capital. This also results in many investors needing to use a syndicate or invest in a trust in order to access commercial property, which then results in less opportunity to control the asset.

Given that commercial property is traditionally a more hands-on investment that benefits most from being part of a diversified portfolio, the risk mitigation strategy of diversification is really only available to the 2.7 per cent of Australian adults that own two or more investment properties.

Those that find themselves in this category, however, may still find that an investment in commercial property is not suited to their personal financial situation, which would have to be assessed on an individual basis.

Posted by Luke Graham, on 12th Aug 2014