Both commercial and residential property have the potential to add significant value to a property investor’s portfolio.
However, there are some key differences between how leasing and renting works across the two different asset classes.
One of the key differences between residential property and commercial property is the rental yield.
Generally, commercial property attracts a far higher rental yield than residential. In a city location in the likes of Sydney or Melbourne, residential property is normally only going to generate a yield of somewhere between 2-4%. While there are differences between property types and inner and out city locations, overall the yield is going to be a lot lower.
Commercial properties normally have rents that are at least double that of residential. In some instances, it’s possible to find yields that are above 10%. One of the reasons this is the case is because commercial properties are tenanted by businesses that can ultimately pay higher rates for well-located and in-demand properties.
These high yields mean that many investments in commercial property will be positively geared which can be an attractive investment strategy. Traditionally, however, residential property appreciates in value at a faster rate.
Longer Vacancy Periods
One of the downsides of commercial property is that it can take some time to find new tenants when a lease expires and the current tenant leaves.
Because it’s businesses that are taking up these leases, they do not move as fast as the typical residential renter. On the flip side, when a business finds a location that suits their needs, or if their business is closely linked to a certain location, then they will likely stay on for a very long time. It’s not uncommon for businesses to operate in the same premises for decades.
Net vs Gross
Arguably the biggest benefit of commercial property over residential is that with commercial leases, the tenant normally pays the outgoing costs.
What this means is the tenant will pay for things like maintenance, insurance, rates, strata fees and water.
These costs can be considerable and we see this with residential properties. While they might generate a 4% yield, when you take into account all the costs and fees, the yield might end up being closer to 2%.
If a commercial property is generating a 7% yield, then that can be very close to what you might receive in terms of genuine cash flow. It is worth noting that every lease agreement is different with commercial properties and should be investigated on a case-by-case basis.
Given that it can be difficult to attract tenants to commercial properties, property owners often take steps to incentivise businesses to take up leases.
They normally do this by offering free rent periods or short-term rent reductions. After a certain period of time, the rent will then revert back to the market rate.
The value of a commercial property is directly related to how much rent it receives and also the length of the lease.
If a property owner can attract a good tenant that can potentially stay on for a long period of time while paying the market rate, the incentive is well worth it.
With a residential property, tenants can leave with minimal notice and they are normally easy to find, so generally, incentives aren’t as common.
Regular Increases Locked In
Most commercial leases link the rate the tenant must pay to the current market rate. That’s usually calculated on a per square metre basis for comparable properties in the area. The other factor that most leases incorporate is that they are adjusted with CPI.
Given that rental income is directly related to commercial property prices, this is why property investors also like this as an asset class, as prices normally rise steadily.
However, like anything in property, ultimately the value of property is determined by overall supply and demand.
With residential, property prices are based purely on what someone else will pay for it and it can be a little more transparent.