Residential or commercial - which should I invest in?

GUEST OBSERVATION

People are pretty comfortable with the idea of residential property investment. 

Most people (I’m guessing) have lived in a house or a unit before; many have also rented them.  So it’s a known quantity and having a few houses in our portfolio makes us feel pretty good.

Now, maybe you’ve been to realestate.com.au on the odd occasion, and you’ve noticed the ‘commercial’ tab on the far right.  A quick search in your local area brings up a plethora of offices, retail shops, warehouses, hotels and even commercial farms, many with the words ‘outstanding opportunity’. 

So is commercial property investment something within the reach of all property investors?  How does it compare to investing in residential property?  Should you be looking to diversify into commercial? 

Well the attractiveness and suitability of any investment boils down to risk vs return.  So let’s compare the two asset classes:

• Returns

Show me the money, as they say.  Here, commercial has the upper hand with returns usually around 6-8%, and sometimes significantly higher for the real 'unicorns'. Residential returns are a little lower at 4-5%, but as you’ll see, less risky and cheaper.

• Vacancy

One of the biggest risks in property is the vacancy rate.  How long can you afford to make repayments and pay outgoings on a property receiving no income? 

Residential property has lower vacancy rates than commercial.  A house or unit may stand vacant for a few weeks before it’s rented, whereas a warehouse, a shop or an office might be vacant for months or years at a time. 

The commercial leasing sector tends to be more affected by the economic climate - they’ll lay off staff and consolidate space when times are tough, causing a contraction in demand for space, whereas individuals still need somewhere to live.  That tends to make the residential property sector a bit more stable.

• Rental / Lease agreements

In the residential world, striking a deal with a tenant is pretty straightforward with much of the common terms (or boilerplate) outlined in a mandated Residential Tenancies Agreement.  All you need to consider are your variables like lease term, rental amount, bond, etc. 

In the commercial world, there’s no statutory authority to tell you how to reach agreement - it’s all up for negotiation (there are conventions though).  Commercial leases run to dozens of pages and include things like incentives paid by the lessor to put towards fit out, and make good clauses, specifying if and how the tenant should return the tenancy when they vacate.  You’ll need specialist property lawyers or a tenant advisor to help with this process.

• Cost

Square metre for square metre, commercial real estate is often cheaper than residential property (unless you’re talking about CBD office space north of $700 a square metre per annum) but because you’re buying more square metres per property, commercial is usually dearer in real terms.  And you have outgoings such as electricity, security, and base building maintenance to consider, however these are passed on to the tenant in some way (net or gross lease). 

In commercial, it’s easier to pass on costs if utility prices climb, but harder to do so with residential property.

• Maintenance

A dripping tap or faulty ceiling fan in a residential property is an annoyance to a tenant and something you should get fixed promptly to keep your tenant happy.  However in the commercial world, tenants tend to be more demanding, particularly if the fault or shortcoming is costing them money - for example the air conditioning breaking down in a shopping centre in summer. 

For this reason, you’ll need a professional property manager with agreements in place with services contractors like air conditioning technicians, plumbers, electricians, security contractors, and who knows the language of that world.

• So which is better?

You may get sick of hearing me say this, but it really comes down to your personal financial strategy, your financial situation, and your appetite for risk & return. 

Before investing in property or any asset class, know what you’re getting into, retain good advice and don’t overcommit yourself. 

For many investors, commercial property represents ‘the next level’ where the scale is greater, the sums are larger, and the returns are higher.

Owen Davis is the principal of DFG Property, a full service property management, finance & sales firm based in Sydney.

Owen has over 15 years experience in property financing, real estate and property management.