ZUVO Commercial Property Buyers Agents

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.

By how much do the yields really differ?

Commercial property yields like any investment vary, they start at around 3% for some very large properties with national and even international tenants on some very long leases, and can go up to 12%-14% for more select, riskier or rural properties. These yields are normally calculated NET, the amount that goes back into your pocket with the tenant paying most (if not all) of your operating costs. In the current market, we try in most cases to secure solid performing properties with a yield at minimum of at least 6% to 6.5% and upwards.

Residential properties however only get a yield from about 3% up to 7%, and that is GROSS, so by the time you factor in costs like insurance, maintenance, management fees, rates etc, that 7% gross yield can be down to 1%-2%. Yes, you can find a 14% or more yielding residential home in a mining town or similar but will you be able to rely on that level of return for the next 20-30  years? Historically the answer is no.

How much are the entry costs?

Commercial property does cost more to get into with the LVR being on average 70%. This means that you need to have a deposit of 30% available. In some cases with the current market conditions some lenders are offering 80% LVR loans. Costs for transacting are very similar though being approx 5% in addition to the purchase price.

Commercial vs Residential Costs

Asset TypeCommercialResidential
Purchase Price$500,000$500,000
Deposit$150,000 (30%)$100,000 (20%)
Stamp Duty$15,925$15,925
Building & Pest$500$500
Valuation$1,200$0
Solicitors Fees$3,500$2,000
Total Costs$21,125$18,425
Total Cash Required Upfront$171,125$118,425

Please note: Commercial property purchase has no GST, bought as a going concern with a tenant in place.

Why would anyone buy a commercial property?

Because of the returns, see below two examples of actual purchases for two different clients. Both properties were purchased in Brisbane QLD with identical price points.

Commercial vs Residential Returns

Asset TypeCommercial Residential
Purchase Price$500,000$500,000
Loan Amount$350,000 (70%)$400,000 (80%)
Yield7.00% (Net)4.94% (Gross)
Annual Income$35,000$22,160
Annual Loan Costs ( 3% I/O)$10,500$12,000
Annual Ongoing Operating Costs$0$7,506
End of Year Balance$24,500$2,654

Please note: Commercial property purchase has no GST, bought as a going concern with a tenant in place.

You can work out from the two examples at the $500K price point, the entry cost difference ($52,700) from the cost table figures above shows interesting results. At this rate the higher entry costs of purchasing a commercial property will be clawed back in just over 2 years, 2.1 years to be exact. This is also not taking into account the 3%-4% annual CPI rent increase that are in most leases for the commercial property, or future rent rises in the residential property.

But after the first three years, and then onto year 5, year 10, year 20… How much ahead will you be financially with the healthier cashflow of the commercial property?

The above two examples have many different variables (loans, interest rate, costs etc) and we have full spreadsheets on them. They are from real-world deals and we’ll happily share them with you.

In fact, we will be releasing a detailed comparison of a commercial and residential property at the $945,000 price point very soon. If you’d like to see it first, get in touch with us. 

Please also note, we haven’t factored in growth of either asset because many will say (and think) that the residential property will outstrip the commercial property with growth over time, when in reality – it won’t. Here is a seperate post on growth of commercial vs residential property.

The real kicker?!

Where this commercial vs residential comparison really hits home in favour for buying commercial, is that most commercial property (if bought well) have the ability to pay down their loans 100% within 10-12 years due to the superior cash flow. That’s right, pay themselves off completely with no cash injections from you whatsoever.

Residential property just can’t do that.

If you want to find out how this is possible, get in touch with us.

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