Residential versus Commercial Property Investments

Making your money work for you: risk vs. reward. Here we discuss residential and commercial property investing in a side-by-side comparison.

Nathan Daly
May 21, 2020

Residential versus Commercial Property Investments

In our Property Climate series, we’ve looked at the Pros and Cons of investing in the Australian residential and commercial property markets. On both sides, there are persuasive arguments to motivate you to join the game as well as “buyer beware.” In this instalment, we compare residential to commercial property investing.

The Definitions:

Residential property is defined by Fortune Builders as single-family type homes and 1- to 4-unit rentals. This includes condos and duplexes, and they are typically leased to families. These types of dwellings tend to be more “hands-on” for the investor as they are responsible for ongoing issues such as routine maintenance and collecting rents.

Commercial property is defined as units, office, retail, industrial, multifamily (more than 5 units), hotels, and special-purpose buildings, such as conference halls and churches. Commercial properties are generally leased to businesses.

When comparing these two investment markets, there are some basic differences that may affect your investment choices.

Tenants:

For investors focusing on single-family homes, the turnover rate is lower than that of commercial properties. It is easier to find quality tenants who are willing to sign a long-term lease. With the long-term lease, tenants are also more likely to care for the home as if it were their own, saving you time and giving you peace of mind.

Since commercial tenants are typically businesses, the professionals who run these operations are likely to respect the property and abide by rules. They will take care of the space because it is a reflection of the business. Yet, many factors contribute to higher vacancy rates in the commercial space, so investors may have to cover a property’s expenses without income support due to unexpected turnover.

Ongoing Costs:

If you’re renting a residential property, you, as the owner, are responsible for maintenance and repairs. If the home needs a new roof or windows, you’ll be digging into your account for the purchase. Likewise, you will be responsible for the fixed appliances and possibly even the grounds upkeep. You will also be responsible for certain regular payments for things such as homeowner’s insurance and taxes.

In the commercial space, everything is negotiable. You may be able to secure a “Triple Net Lease”, wherein the tenant pays all property expenses directly, including taxes. The property owner is responsible only for mortgage payments. If you’re curious as to who would be interested in this type of lease, think Starbucks and Woolworths. Big businesses tend to prefer this arrangement as it allows them to develop a “look and feel” that is consistent with their brand image.

Return On Investment:

While the commercial space may bring higher rental rates, the risks are lower with residential. Vacancy rates tend to be lower, so it’s less likely there will be an interruption to the income stream. Depending on your property and location, the investment will grow in value according to property-price increases. Aside from generating cash flow, the real gain on residential property is in the long-term investment - the value of the home and property over time.

Commercial properties have a different dynamic. While commercial property experiences slower rates of capital growth, the goal with this investment is to generate income. Average commercial property yields are from 5 to 12%, outpacing residential returns which are typically only 3 to 4%. However, the risk is higher, too. Businesses fail with great regularity, and unless you have a contract with a well-established business, the vacancy rate can be problematic.

Funding Options:

If you have good credit, proof of income, and a sizable down payment, most banks are willing to underwrite traditional first mortgages and can offer a reasonable interest rate for home loans. Credit Unions and Building Societies, known as Tier 2 lenders, will also underwrite first mortgages, and they tend to be a bit more flexible and willing to work with clients with less-than-stellar credit. If you’re self-employed, just changed jobs, or have irregular income, the Tier 2 lenders may still be willing to work with you. But if you have one of these scenarios, and you need funding fast, private lending might be your best option - and the world of P2P lending is getting stronger and more competitive daily, driving down prices and opening doors of opportunity to the average working Joe.

For commercial mortgage lending, securing a loan will be a little more tricky. To obtain financing through a bank or a Tier 2 non-bank lender, you will need to be prepared with a business plan, good credit history, a cash-flow projection, and time as it can take months to get commercial loans approved through traditional channels. Plus, banks will require a larger down payment, up to 30% in some cases.

Private lending, however, is making a strong appearance in this arena, offering a variety of products with a quicker approval process. Of the products available for commercial investing, private lenders can provide interest-only loans which are a great short-term solution and instrumental in securing a deal quickly. The payments are initially very low, allowing you to close the deal and generate cash flow so you can restructure your loans at a more opportune time.

If you’re interested in the development aspect of commercial property investment, you can obtain development finance or construction finance through P2P lending. Private lending is more flexible and faster. And with a partner like Acumen Finance, the underwriting can be much more creative as we will consider the merits of the deal and any special or technical features on a case-by-case basis.

Getting Started:

Residential property investing is a great way to get into property investing. It is small scale and relatively easy to handle. The risks are low as you’re betting on growing property values which tend to increase over time - as much as doubling every seven to 10 years. And since tenant turnover is lower than it is in commercial properties, it is a reliable source of income.

Banks love home loans because of the low-risk, so you can usually get a decent interest rate on a long-term investment - typically 30 years with the balance amortised over the length of the loan, keeping payments manageable. Most attractive to smaller investors is the fact that there is a lower cost of entry, making the market more available to more people.

On the other hand, in the commercial market, there is a wider range of investment opportunities - from property type to location to passive-commercial investing. And contrary to some popular beliefs, there are commercial opportunities at reasonable entry points; for example, a car park or a small office building in a nice location. So the average investor should not discount the commercial space without further investigation.

Having said that, banks consider commercial investments to be riskier - they are more susceptible to economic fluctuations and experience higher vacancy rates. Therefore, you can expect bank loans to carry a steeper interest rate. The commercial property market may seem like the big leagues, and small investors may feel more comfortable with something more familiar. But for those who really want to expand their portfolio and make their money work for them, the rewards of commercial investing might be worth the risk.

When deciding which is right for you, consider your long-term goals, your risk tolerance, available credit and the time you can devote to the project. When you’re ready to make the move, contact a professional who knows all there is to know about investment lending, financing options, and loan structuring to make the most out of your deal. Acumen Finance has over 38-years combined experience among its management staff and has handled hundreds of residential and commercial investments. With a direct connection to a pool of sophisticated investors, Acumen will match lenders and borrowers based on the project goals and merits. Contact us today.