Commercial vs Residential Real Estate

Commercial vs Residential Real Estate. There are many factors a property investor should consider when comparing commercial and residential real estate investing. Commercial tenants are usually of a business nature, running businesses from the property, while residential are generally for live-in accommodations. Commercial real estate investment is perceived to be expensive and unaffordable. This could probably be defined as half-right. We always hear of significant commercial property transactions; examples include large commercial buildings such as office towers, retail shopping centres, and international hotels.

Most people have a good understanding of residential property, as most of us have owned or currently own a single-family home. So we feel safe investing in residential property.

Bank finance for Residential and Commercial Real Estate Rental Properties

Bank lending is usually easier for residential real estate investors, even though they usually have much shorter lease terms. Generally, banks require smaller deposits when people are purchasing a residential property. Deposits could be as low as 10%. While around 30% or higher, especially for commercial property. With the current situation and the changes in lending policies, finance has become more complicated, and higher deposits are usually required.

Up until recently, interest-only loans have been popular, but this is changing with the new lending requirements. This means that the payments and possible interest rates are also higher. You may be asked to prove a higher income and a strong long-term cash flow to service the debt.

Residential Investment Definition

The residential investment definition refers to the purchasing or construction of houses or apartments for the purpose of either renting them to other people or living in them as a multiple or single family or person.

The important component in determining the value of residential structures is the rate of population growth in the surrounding area. Market factors show that as the demand for new housing increases, there is also a corresponding increase in house prices.

Because most owners have to borrow funds to purchase homes, the prevailing interest rate can reduce affordability. In a situation of high interest rates, this can be reflected in lower demand for residential real estate and possibly lower prices in the short term. 

When you have a higher demand for residential property rental income, investment prices usually follow upward. This also results in higher capital gains and increased demand for residential property.

Most investors consider residential housing to be a more long-term and popular type of property investment compared with commercial properties.

Can a residential property be used for commercial purposes?

Many investors ask whether residential property can be used as commercial property. The short answer in many cases is that it can be. There are many factors to take into consideration with commercial and residential real estate.

I have found that the crucial factor is the current zoning. This can vary from area to area. The other factors include traffic, proximity to public transport, additional services, and the effect on the quiet enjoyment of the local community.

Some commercial uses that are possible in low-density residential areas include childcare centres, boarding houses, retirement villages/over 55 developments, and nursing homes.

Many low-density residential areas also allow the whole or part of the property to be used for low-impact commercial services. Approved uses can include hairdressing, doctor surgeries, accounting services, clothing repairs, etc. The primary consideration is local zoning. Generally, the uses are allowed depending on the effects on the local community, with minimal traffic and noise impact.

It is recommended that commercial investors check  approval conditions and local building codes with your local council before considering undertaking any of these projects

Any changes to the use of a part or whole of a property will usually require a development approval application. Failure to gain change-of-use development approval can lead to heavy fines and possible demolition.

Residential Real Estate with an Attached Office

Recently, there has been a growing trend to have commercial office areas attached to residential multi-unit developments. With the recent pandemic, this trend looks likely to continue.

Commercial buildings with an attached residence

Over the years, there have been many commercial office buildings that have had residential accommodations attached to them. These have been in strip shopping centres, usually on busier roads. The commercial component is traditionally separated from the residential component, with different access to each.

The popular classification is mixed-use properties. In addition to commercial, other business purposes can include industrial and rural.

The advantage of this is that the owners can live in the residential accommodation and lease out commercial components to a separate tenant, usually on long-term leases. This will most likely have tax implications. One disadvantage is that mixed-use real estate can be more challenging to finance.

What is the general rate of return on the Commercial and Residential Types of Investments video?

Generally, investing in commercial rental property has higher income returns (cap rates) compared with residential property investing. When journalists quote income returns for residential property, they usually cite a gross income figure. With commercial property, outgoings are traditionally paid by tenants, while residential owners typically have to pay most outgoings. A gross income figure is the actual rent paid by the tenant to the landlord.

When negotiating commercial leases, the tenant negotiates a net rent plus a percentage of the outgoings. For example, if they lease 10% of the building, they would usually be liable to pay 10% of the total outgoings. In a residential situation, tenants usually pay for all their water usage on top of their basic utilities such as electricity, gas, and telephone.

What are typical property leasing periods?

Generally speaking, when comparing both types of investments in a regular market, it is usually easier to lease out a residential rental property than a commercial one. Depending on the current situation, residential properties only take a few weeks to lease. On the other hand, during unfavourable economic conditions, some commercial properties can take many months to lease out. Commercial investment property usually has more extended leasing periods. Most residential leases are around 12 months, while commercial contracts are generally 4 to 10 years and sometimes longer. So residential investments typically have more regular downtimes, while commercial ventures have fewer and more extended downtimes between tenants.

How much can a landlord increase my rent?

Commercial real estate leases usually have annual increases. From our recent transactions, we would estimate that around 80–90% of commercial leases have yearly increases of 3%, or (Consumer Price Index) CPI, while the remaining balance of 10–20% of lease terms is either 4% or 5% annual increases, or a combination of CPI plus 1 or 2%. These higher increases are more common in major retail shopping centres.

We have also noticed that some commercial (non-retail) leases might have increased in the higher of CPI or fixed rise. Generally, this can protect landlords from a low CPI increase.

Some lease contracts have clauses that say the rental can be subject to market review during the option period. In most cases, this can protect both the lessor and lessee from significant fluctuations in rental market conditions.
Residential rents are usually reasonably stable, with less frequent increases. Most changes in rent paid are negotiated with a new lease agreement.

How do you work out the value of commercial and residential investment properties?

It would be a good idea to have a residential and commercial property checklist to take into account your requirements. These will include the following:

Cap Rate.

The most common method of valuing commercial real estate investments is by their cap rate. The cap rate is the cash flow return on the price of the property.

For example, let’s say that you are looking to buy a commercial office with a current annual net rental return of $150,000 per year. You observe that similar quality offices in a similar area are selling for a 5% cap rate (net yield). Taking this into account, you would estimate a fair market price of $3,000,000.

Residential properties are usually compared based on the gross rental, which includes outgoings.

Other methods can include:

Direct comparison

The direct comparison method involves comparing like with like. For example, if a similar property was sold for the same price, taking everything into account—position, build quality, land size—

Replacement Value.

The replacement method takes into account the cost of rebuilding the structure. This is separate from the value of the land.

An example would be a house or commercial property worth $1,000,000 built on a block of land valued at $1,200,000. The estimated value would be $2,200,000. You would then have to take into account depreciation.

Highest and Best Use.

Some properties can be underutilised. You may have a property with a low yield or cap rate that is rezoned for higher use. For example, it may be zoned for a block of units or a high-rise commercial building.

What type of investment property shows higher capital gains?

Generally, when comparing commercial vs. residential real estate (not always), capital gains are higher with residential property.

In the last 4-5 years, we have seen spectacular capital growth with residential property in Sydney and Melbourne. In fact, this trend has been reflected in many major capital cities and regions throughout the world. Generally speaking, residential property demand usually increases with population growth. On the other hand, commercial investment property prices are often a reflection of the current business environment and the structure of a lease. e.g., a longer leasing period may indicate more stability in the investment. Although capital gains for commercial property are usually lower, some commercial properties can achieve spectacular capital gains for commercial investors. Some of these factors could also be local population increases, changes in use, redevelopment or zoning changes. Also, some commercial property investments do have residential tenants. For example, this could be a boarding house, which, in theory, is like a mini block of units.

Can a business rent a residential property?

With different zonings, there can be a fine line between commercial and residential. The question is, “Can a business rent a residential property? The simple answer is that it depends on what is permissible on the property.

Can you run a business along with a residential tenancy?

With the current growth of people wanting to work from home, most clerical or office-type of home business uses (depending on which state or country you are in) are generally allowed. In that situation, someone can either own or rent the property as a residential rental and use part of it for small business purposes. Many councils allow other local types of businesses, such as hairdressers, accountants, or consultants, to operate in residential zoned areas.

There can be legal issues that should be discussed with your lawyer as well as the Australian Taxation Office (or tax office in your country). These are issues that should be covered with your accountant.

Is it possible to run an entire commercial business from a residential property?

Depending on the local council zoning, there are various commercial uses permissible on residential property. Some of the more common ones include childcare centres and boarding houses. In order to be allowed to run this type of business from a rental property, there would have to be modifications for compliance.

Should you allow commercial uses for your residential investment property?

This is a commercial decision you have to make after speaking to your attorney and accountant. In most cases, allowing for commercial uses on a residential property can give you a better return. On the flip side, it may also mean more wear and tear on your property.

Selling Commercial Real Estate Vs Residential Real Estate

Which is harder to sell: a commercial property investment or a residential property investment? The answer to selling commercial vs. residential real estate depends on many factors. Generally, residential real estate is easier, but there could be situations where it could be the opposite.

The residential market works on supply and demand for living accommodations. People always need a place to live, whether the economic conditions are good or bad. This can include increases in migration rates to the area due to better employment opportunities and new developments, making the local real estate market and location more desirable.

Residential leases are often shorter than commercial, rarely over 12 months. Despite this, most investors believe that they are a safer investment property and often achieve a higher capital gain.

On the other hand, commercial investments can be affected by economic conditions. In unfavourable economic conditions and periods of higher interest rates, they are seen as higher risks. They are less attractive than residential, even though they generally have a higher return on investment.

Commercial and Residential Investment Property Cycles

Investment properties work in cycles. Commercial investments with quality commercial tenants with longer leases are often seen as suitable long-term investments despite the higher cost of purchase, as these attract more interest due to higher rental income and a better rate of return than residential.

Also, commercial leases are longer, often 6 to 10 years. Usually, they are long enough and generate sufficient cash flow to secure finances for purchase, depending on the quality of the property and tenant(s). This increases buyer competition and leads to better prices.