Investing in residential property versus commercial property

Investing in residential property is a great way to grow your wealth and secure your financial future. But these days, with the yields so low, it might not be as lucrative as investing in commercial property.

Investing in commercial property is often where you will find the most bang for your buck – especially because most commercial purchases are valued based on their rental return.

In the residential market, a property must increase in value for the buyer to profit, but commercial property can create wealth even without capital growth. And in general, commercial net returns are much higher if you get it right but can be riskier if you buy a bad property.

So, how can you decide whether commercial property investing is right for you? Let’s look at some of the key differences between investing in residential property versus commercial property.

Investing in commercial property is often where you will find the most bang for your buck

Key differences in the amount of deposit required

The first perceived disadvantage of investing in commercial property versus residential property is that you’ll need a larger deposit.

Lenders generally allow a loan to value ratio (LVR) of only 60% to 80% per cent for commercial property, whereas residential property lenders will allow LVRs of 80% to 90% – sometimes even up to 95%. In other words, you’ll likely only need to pay up to a 20% deposit for a house or apartment. But with commercial property, you’re likely to have to pay a 20% to 40% deposit.

However, if you look at the percentage value in numbers, it is often cheaper to enter into the commercial property space. The entry-level commercial property can be as low as $50,000 for something like a car park or a regional office. Even in capital cities, you could find an industrial space for as little as $150,000.

Beyond that, because commercial property often boasts better cash flow opportunities, that extra deposit is likely to be paid off within two years of owning the property.

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Commercial property offers higher rental yields and better cash flow

Commercial properties are known for their higher rental yields in comparison to residential properties.

With residential property, the gross yields are typically between 3% and 6%. But because residential properties incur considerable outgoings such as council rates, water rates, body corporate fees and maintenance, your net yield is likely only to be around 1% to 3%.

Most residential investors settle on a negatively geared property hoping that the eventual capital growth will outweigh the short-term loss. While this could be the case, you might run into cash flow problems in the long run which could mean that you might have some problems servicing the loan.

On the other hand, commercial properties typically average around 5% to 8% net yield. And tenants are generally responsible for the outgoings. So, there’s an opportunity for a much greater net cash-flow return – meaning you could focus on expanding your portfolio.

Commercial properties typically average around 5% to 8% net yield

How does a commercial property’s capital growth compare to a residential property?

There is a common misconception that commercial properties don’t experience the same capital growth rate as residential properties. If this were the case, you’d be able to buy in the commercial market much cheaper than in the residential market.

Most commercial properties have shown at least the same growth as residential properties. However, within the overall market cycle, the capital growth of different commercial properties can vary depending on demand for the property and its type, purpose and location.

If you do your due diligence correctly, you can mitigate most market fluctuation risks and profit in the long term.

Lease stability and vacancy rates

Leases on residential and commercial properties can be as little as month to month. However, residential leases generally range between 6 and 12 months, whereas commercial leases range from one year to 30 years.

In most cases, residential tenants want the flexibility to move should their circumstances change, so that is why you’ll find that residential leases are slightly shorter. On the other hand, commercial tenants want the security of knowing they’ll be able to remain at the location long term.

This also means that vacancy rates are a significant point of difference between residential and commercial property. For example, residential properties in a well-chosen area will usually have a vacancy rate between one and four weeks each year, while commercial properties in a high-demand region will typically have a vacancy rate of one to six months.

Tenants of commercial properties are less likely to move because their livelihood is attached to the business, and they’ve paid for the fit-out. But, if you get it wrong and buy a commercial property in a risky area, it could mean that you’ll experience long periods of vacancy.

Having the right marketing agent and fair rent pricing can assist in leasing a vacant property more quickly. However, it’s good to have some kind of cash buffer to cover longer periods of vacancy.

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How do loan interest rates differ between residential properties and commercial properties?

Commercial loans will generally have higher interest rates compared to residential loans. This will typically be around 0.5% to 1% higher – however, this will completely depend on:

  • the type of loan,
  • deposit amount,
  • type of property,
  • and the risk.

One of the reasons why commercial loans have slightly higher interest rates is because they have a shorter loan term, which raises the monthly mortgage payments significantly. They also have a smaller secondary business market, so there is less competition between the lenders to provide a better rate.

What about depreciation?

Depending on the age and style of the building, a commercial property will usually have higher depreciation due to the more expensive construction and fit-out, so this can be an advantage as higher depreciation means greater tax deductions for the owner.

Commercial property will usually have higher depreciation due to the more expensive construction and fit-out

Key takeaways

For those looking to invest in property, deciding whether or not they should choose residential properties versus commercial properties can be difficult.

If you are considering investing in commercial property or residential properties, there are a few key factors to consider, including:

  • deposit requirements,
  • how much capital growth you want and in what period,
  • your cash flow requirements,
  • potential for vacant periods,
  • loan interest rates, and
  • depreciation.

However, there are risks involved with both options, so it simply comes down to personal preference, due diligence and having the right advisors in your team.

The returns on commercial property can be spectacular compared to residential property. And, as you’ll see, you can mitigate almost all of the risk with thorough due diligence. But, for me, commercial property was the game-changer, providing instant passive income and financial freedom.

Want to find out more about investing in commercial property?

One of our experienced property experts can talk you through the process and help you determine if investing in commercial property is the right for you