Commercial vs Residential Real Estate

Commercial vs Residential Real Estate. There are many factors to consider for the real estate investor when comparing Commercial and residential real estate investing. Commercial tenants are usually of a business nature running businesses from the property while residential is generally for live-in accommodation. Commercial Real Estate investment has a perception of being expensive and unaffordable. This could probably be defined half right. We always hear of significant commercial property transactions. Examples being 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 an owned or currently own our own a single-family home. So we feel safe in investing in residential property.

Bank finance for Residential and Commercial Real Estate Rental Property

Bank lending is usually easier for residential real estate investing. Generally, banks require smaller deposits when people are purchasing residential property. Deposits could be as low as 10%. While around 30% or higher with commercial property. With the current situation of the changes in lending policies, finance has become more complicated, and higher deposits are usually required.

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

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

Generally investing in commercial rental property has higher income returns (cap rates) compared to 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 an 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. With residential situation, tenants usually to pay for all their water usage on top of their Basic utilities such as electricity, gas, and telephone. Cash flow returns on investment vary. At the moment, rental terms for residential are around 3 to 4% mark Gross. This equates to about 2 to 3% net.

On the other hand, good quality commercial property with blue-chip tenants with a reliable property manager, e.g., national tenant in a prime retail space in major cities of Australia is currently showing around the 4 to 6% mark net. In some situations where the current rent is below market value, or the site is possibly potentially a significant development site could show a lower rate of return.

 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. 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 less 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 balance of 10-20% of contracts being 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 commercial leases) can have increased in the higher of CPI or fixed rise. Generally, this can protect the landlords from a low CPI increase.
Some lease contacts have clauses that the rental can be subject to market review at the option period. In most cases, this can protect both the lessor and lesse 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 new lease contracts.

How do you work out a commercial & residential investment property value?

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 are by their cap rate. The cap rate is the cash flow return on the price of the property.
For example, let 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 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 on the gross rental, which includes outgoings.

Other methods can include;

Direct comparison

The Direct comparison method is comparing like for like. For example, if a similar property was sold for the same price when taking all things like position, build quality, land size into account.

Replacement value.

The replacement method takes into account the cost to rebuild structure. This is separated from the value of the land.

An example would be a house or commercial property worth $1,000,000 to build 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, which 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 (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 & 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 often a reflection of the current business environment and structure of lease. Eg.  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. Some of these factors could also be local population increases, change of 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.

Summary

In summary, when considering real estate investments, how you decide to buy between Commercial vs Residential Real Estate will take into account many items. It all boils down to your financial situation and your long term and short term investment property strategy.

Like to discuss further? Contact Con Tastzidis at CST Properties Commercial Investment Real Estate Agents on 9882 2221

The information in this article is of a general nature and not meant to be any financial advice. Any investing does carry an element of risk. Please consult your financial advisor before you buy.