Commercial property investment not for everyone

With our residential property markets in a slump over the last few years, some investors are wondering if it’s worthwhile considering commercial property. 

They see that these are the type of properties owned by people in the BRW Rich 200 list and the big institutions; and they hear of high rental yields, long term leases and tenants paying the outgoings. All this makes commercial property sound very appealing. 

So let’s do a Q&A to find out a bit more:

 Q: What are commercial properties? 

A: Commercial properties consist of shops (retail), factories and warehouses (industrial), and office space (commercial). 

My experience shows that commercial real estate has – both historically and in recent times of economic turbulence – proven to be significantly riskier for investors than residential real estate.

Q: What’s the fundamental difference between the two types of investment? 

A: These are very different investment vehicles. Residential property is a high-growth, low-yield investment while commercial property is a higher yielding but low-growth investment.

The values of commercial properties are yield-driven rather than (owner-occupier) demand-driven in residential property and fluctuate over time related to yields available from other investments and the prevailing interest rates.

As most commercial rental increases are usually pegged to the rise in the CPI, your rent increases at around 2% or 3% each year, stifling your capital growth. Then when the economy falters and businesses languish, commercial property tends to be out of favour and drops in value. 

Q: If the total return is similar, why not go for the investment with the higher cashflow, in other words, commercial investments? 

A: The fundamental job of property investors is to build themselves a substantial asset base to one day create a “cash machine” to replace their personal exertion income. This is much easier to do with capital growth, which is not taxed, than with cashflow, which is taxed. 

Q: How else does commercial property investment differ from residential real estate investment? 

A: There are considerable differences between the two types of property which may make them a less safe option for beginner real estate investors: 

Commercial properties tend to yield a higher return than residential properties – usually between 7% and 10% net compared to residential properties which yield 4.5% to 5% gross (then subtract rates, taxes, insurance, etc). Professional investors require a higher rental return to make up for this type of property’s inferior capital growth and longer vacancy factors. 

With commercial properties, the tenants usually pay all the outgoings such as rates, taxes and insurance. 

Because your tenant conducts their business from your commercial property, they tend to look after it better by maintaining the property, including painting it, and most leases require the tenant restore the property to its original condition at the end of the lease.