Best Investment Strategy: Commercial vs Residential Real Estate
Commercial vs Residential Real Estate —What’s the Difference?
Property investors will have to decide early on in their investment journey whether to invest in commercial or residential property. This involves considering the pros and cons of commercial real estate and residential properties and one’s investment strategy, resources, and goals.
Let’s break down each type of property, as well as the benefits of both, and answer the question ‘should I invest in commercial or residential property?
What is Commercial Property?
These days investing in commercial property is becoming more and more popular. Commercial properties are usually set up to create a commercial space, with the property being used for a business to generate income. These properties can range from office buildings, industrial properties, warehouses, retail shops, hotels, and schools.
What is Residential Property?
A property is usually considered a residential property intended to be occupied as a residence. The length of this occupation and whether the property is to be occupied by the owner or by a tenant is irrelevant. Examples of a residential property include a house, apartment, flat, townhouse, or unit.
Let’s now consider the benefits of both to determine whether residential or commercial property investment is suitable for you.
Benefits of Commercial Real Estate Investing
A significant benefit of investing in commercial real estate is that the yield is generally greater. Commercial properties can offer net profits of 5-7%. This is compared to the 3-4% net yield in residential property investments.
Net yield or partial net gain, rather than gross yield, is also more common in commercial real estate. This means that the tenant pays property management fees, insurance, maintenance costs, land tax etc. These expenses are often billed to the owner in residential, affecting cash flow.
However, not all commercial assets offer net yield, which means that you will still be required to cover these costs in some instances. Despite this, commercial property can still have a slightly better result than residential, with a commercial asset sitting at around 6% net yield dropping to about 4.5-5% after fees.
There is also more longevity in a commercial real estate lease. Commercial leases are usually around 1-5 years, whereas residential leases, on average, sit at 6-12 months.
Investing in residential property means you need to outsource management responsibilities, especially if you don’t live close by. This is much easier in a commercial space, as you can usually self-manage, reducing cost if you have a bit of time.
So, is commercial property better than residential property? Let’s first have a closer look at the benefits of investing in residential real estate…
Benefits of Investing in Residential Real Estate
The first benefit of residential properties that you’ll come across is the deposit. Usually, a 10-20% deposit is required for residential real estate, while 30% is a safe bet for commercial properties.
This margin is considerable, as 30% of a safe commercial asset (usually between $700,000-$800,000) is a significant amount more than 10-20% of $500,000 residential property. Getting started in residential investment is much easier, as the deposit is smaller.
Vacancy rates are also much lower when investing in residential property. Generally speaking, the average residential vacancy is less than a week per year. In commercial property, the average is just over a month per year.
Whether you are comfortable with this average commercial vacancy rate will depend on your cash flow resources, as commercial investors may have to still pay for a property’s outgoings without the support of rental income.
Another benefit of investing in residential real estate is that interest rates are generally lower.
Value add-in may be another factor, but generally, this can be done for commercial and residential property. This may involve subdividing, renovating, splitting, or developing the property into residential property.
Value add-in for commercial property usually involves increasing rent, negotiating an increase in the rental period, or subdividing. Both types of investment property have procedures to manufacture equity, with no real benefit in going with one over the other.
While not a distinct advantage, keep in mind that capital growth in residential real estate is entirely dependent on location. This is a bit more complicated in commercial assets, with capital growth dictated by location, as well as an increase in rent each year (valued by what yields comparable assets have sold for) and by yield compression (this means that rent has not necessarily gone up, but more people want to buy that asset for a lower yield.)
So, with all these considerations, which is a better investment: residential or commercial property?
Which is the Better Choice?
There is no quick and easy answer to this question. There are benefits for residential and commercial properties that will suit different investor strategies, resources, and goals.
When making these decisions, it’s probably best to break them down into two groups and see which one you fall into. If you have more than a $200,000-300,000 deposit, if your cash flow can accommodate a six month vacancy period every five years, and if you prioritise cash flow, then commercial is the way to go.
You should be investing in real estate properties if you have $40,000-$150,000 for a deposit, if you need cash flow to be consistent and regular, and if you are relying on capital growth to refinance properties and use that equity to fund future deposits.
Hopefully, this has helped clear a few things up regarding the commercial vs residential investment debate. But we understand this is a complicated decision, and further consideration is likely still necessary.