Should you invest in residential or commercial property? Mark Armstrong

I often get asked is residential property a better or worse investment than commercial property, but the answer is neither. Both asset classes can be great investment options, but it all depends on what the investor is aiming to achieve. This is because they are different types of investments with different characteristics that will help investors achieve different objectives.

For example, commercial property is more likely to produce a strong income stream because tenants of shops and offices pay more rent than residential tenants. Also, in most cases all outgoings such as rates and insurance are covered by the tenant, further boosting cashflow.

However, on the flip side capital growth potential is relatively low. Land appreciates (increases) in value, while buildings depreciate. The higher the proportion of land relative to the property’s overall value, the higher the capital growth potential.

With commercial properties, the building often takes up the lion’s share of the value. This low land value often means capital growth is relatively low. Therefore, the key advantage of commercial property lies in its ability to attract high rental returns.

The best commercial property is usually found in high population growth areas such as the outer suburbs with increasing demand from residents for goods and services provided by petrol stations, fast-food outlets and supermarkets.

This is the reason large commercial property trusts such as Westfield invest hundreds of millions of dollars in areas such as South Morang in Melbourne’s north. Surrounding growth suburbs such as Doreen and Mernda have experienced a population explosion in the last five years, and all these people need to spend money to live. This money flows straight into the coffers of the commercial property owners, and as population grows so does their income.

The large property trusts also target the CBD because of the large daily influx of office workers and growing population.

Because commercial property doesn’t have high capital growth potential to counterbalance the interest on a loan, it’s wise to borrow as little as possible (0 to 30%) and fund the purchase with cash.

Residential property, by contrast, doesn’t produce a high income stream because residential tenants can’t pay as much rent as commercial tenants. Landlords are also required to cover rates, and building insurance on the property further diluting their cashflow.

On the flipside, residential property tends to have better capital growth potential because the land usually makes up most of the property’s value and there is a more consistent underlying demand from people who need a roof over their head.

The best residential investment property is usually found in areas with moderate but consistent population growth driven by demand from home buyers, investors and tenants alike. Consistent demand drives land values, which in turn fuel capital growth.

Land values are highest in established areas where there is no more land to build on, such as the inner and middle suburbs. Suburbs such as Richmond or Elwood are highly sought after by residential investors, who already control more than 50% of the residential property in these markets.

Because well-chosen residential property can provide enough capital growth to offset the interest on a loan, investors are more likely to borrow a higher proportion of the purchase price than if you were buying commercial property.

If an investor is looking for capital growth and doesn’t have the cash to purchase a commercial property outright, he or she should focus on residential property. If you purchase in a location where land values are high, the capital growth will be enough to balance out the interest you’re paying on the loan. And, because the property will be producing income, your interest payments will be tax deductible.

Alternatively, an investor who has accumulated a significant nest egg and is now looking to generate income would be wise to focus on commercial property. With low borrowings and higher rental yields, the investor’s money would be producing an income and the investor might not have to work.

Mark Armstrong is a director of iProperty Plan, which provides independent analysis and tailored advice to investors and home buyers.