What is the difference between commercial and residential property?

The main difference between these two types of properties is that commercial properties are used for business purposes and residential properties are used as homes that people live in. Consequently, commercial properties are more vulnerable to economic changes and fluctuations than residential properties and are, therefore, considered by some higher-risk investments. But the upside is that they also offer consistently much better returns.

Here are the main ways these property types differ.

Lease length
Typically categorised as either office, retail, industrial or special purpose, commercial properties have much longer leases than residential properties, and these leases play a crucial role in determining their value. This is because it’s much harder to replace a commercial tenant than a residential one, as commercial properties are more vulnerable to economic flcututaions and changes than residential properties.

Lease terms
While there’s little variation between residential leases, the difference between commercial leases can be extensive, with pretty much every clause, term, provision, requirement up for negotiation. Consequently, commercial investors have to work very closely with solicitors when drawing up a lease. But don’t let that scare you, the cost is roughly double to conveyancing fees for a residential property, which in the scheme of things when the higher returns are factored in, are negligible.

Rental yields
Commercial properties typically offer rental yields between 3% and 12%, whereas residential properties typically offer around 3-7% yields. As a result, commercial investments are more likely to be cash-flow positive than their residential counterparts.

Annual rent increases
Unlike residential leases, most commercial leases include fixed annual rent increases. These typically fall within the range of 3-4%, which is higher than the current level of inflation (1.7% in the 12 months leading up to December 2019).

Vacancy periods
A combination of factors mean that vacancy periods in the commercial market tend to be much longer than vacancy periods in the residential market. This means that commercial investors will often have to cover a property’s outgoings without the support of rental income. One of the main reason why re-let ability is paramount before you buy any commercial property, get this right and your vacancy period can be reduced considerably.

Maintenance and repairs
In the world of commercial property, it’s more common for tenants to sign net leases than gross leases. This means that they are responsible for paying council rates, insurance, land tax, maintenance and repairs. Meanwhile, in the residential market, these expenses are billed to the landlord, which is yet another reason why it’s more common for commercial properties to deliver a positive cash flow. Commercial investors, however, are required to weigh up this benefit against the higher cost of repairs more broadly. Combined with the increased potential for extended vacancy periods, the higher cost of upgrading a commercial property means that commercial investors generally need to have access to more readily available capital.

The tenant 
That commercial tenants use their rented premises to run a business means they have a stronger incentive to take care of the property. They tend to be easier to manage and you generally have more than 2-4 weeks notice when they intend to vacate (from 3-6 months generally).

The lease will also require the tenant to undertake (and pay for) any required maintenance for the duration of the lease. And when the time comes for them to leave, there is also a clause requiring them to “make good” beforehand. An obligation to hand back the premises in good repair and to reinstate the premises to the condition that they were at the start of the lease

Finance
Commercial investment is catagorised differently than residential investment, hence banks generally require a minimum deposit of 30% for commercial properties but often lend to residential investors with smaller deposits (10%-20% dependant on your personal situation). What’s more, commercial loans generally attract higher interest rates and administrative fees, purely because banks can unfortunately.

Exposure to economic changes
While people always need a place to live, demand for a business’s goods and services fluctuates, which means that demand for commercial property is more variable than residential property demand.

Knowledge required
Commercial investors need to have a deeper understanding of the broader economy than residential investors, because demand for commercial properties is more sensitive to economic changes and fluctuations. As a result commercial investors generally need to be more mindful of the current economic climate and conduct thorough research into various economic drivers before buying a property.

Capital growth
While this point is fairly divisive, the majority argue that commercial properties experience slower rates of capital growth than residential properties. This just not true. This scepticism exists really because most residentially inclined investors just don’t understand commercial property and their differing cycles and dynamics with respect to residential property. Which is why we keep emphasising why the lease and tenant are of paramount importance to a commercial property’s value.