RESIDENTIAL VS. COMMERCIAL PROPERTY INVESTING: HOW THEY COMPARE

Commercial property tends to be seen as a defensive, income-focused, lower capital growth investment. Residential property, in contrast, is viewed as a more speculative activity.

The table below makes the point. Note commercial property has an effective cash yield close to double that of residential yields.

Then there’s the short-term leases in residential compared with commercial, the more volatile returns and legal protections favouring residential tenants. There are risks that residential property investors take that commercial property investors do not.

But it’s the intention behind the investment that’s the biggest difference; because effective cash yields are typically lower, residential property investors are in effect banking on higher capital growth to compensate for a yield that may not even beat inflation.

Commercial property, meanwhile, is regarded as a defensive investment due to the predictability of rental income sourced from a diversified pool of high-quality tenants.  Even during volatile economic conditions, the rent continues to be paid due to the contractual obligations of the lease.

RESIDENTIAL V COMMERCIAL – THE KEY DIFFERENCES

Residential property Commercial property
Effective cash yield1 2-4% per annum Around 4-7% per annum
Property types Houses, apartments, flats and townhouses Office, retail, industrial, and others such: as healthcare, hotels and storage facilities.
Leases Short term (typically one year) Long term (typically 5+ years)
Rental reviews Upon lease renewal, determined by local market conditions Most lease contracts have locked-in annual rent reviews linked to fixed rates or CPI
Tenants Individuals Businesses, ASX-listed corporations and government bodies.
Legal protection Across states the Residential Tenancy Act favours the tenant Generally, balanced legislation between landlord and tenant. Commercial tenancy agreements are dealt with as business contracts and are negotiated at arm’s length between the parties.
Property costs The tenant is required to maintain good order. Costs are largely borne by the landlord.

Most leases will provide for outgoings to be paid by the tenant and typically include: council rates, water rates, land tax, insurance, strata levies and property management fees. 

Tenants are required to “make good” or return property to the original condition at the start of the lease. Majority of costs are borne by the tenant.

It’s horses for courses, really. You may be happy to assume that residential property prices will rise, and you may be okay with an effective cash yield not much better than that paid by a risk-free term deposit. There are many people making the same choice, in which case commercial property may not be what you’re looking for.

But if your focus is on a higher, more stable income from which you can cover day-to-day living expenses, with the potential for sustainable capital growth on top, commercial property may well be a suitable choice for you.

HOW COMMERCIAL PROPERTY HAS PERFORMED

Does this mean the benefits of a stable, regular income come at the expense of total returns? Not at all. The chart below shows that since December 1984 commercial property has delivered a total return (income plus capital growth) of 9.4% p.a. over the past 34 years!

IPD Australia All Property Index

Source: The Property Council / IPD Australian Property Index, produced by MSCI, measures unlevered total returns of directly held standing property investments from one valuation to the next. The index tracks performance of 1,422 property investments, with a total capital value of AUD 192.1 billion as at December 2018.

Still, most income investors would probably have been happy with these returns of this nature over the past 34 years. An impressive figure, especially taking into account the level of risk. Of course, investments can go up and down and past performance is not indicative of future performance.

WHY COMMERCIAL PROPERTY IS AN EXCELLENT DEFENSIVE INVESTMENT

Why is commercial property regarded as a defensive investment? Mainly because of the predictability of the rental income and cash flows it delivers. As a potential commercial property investor, it’s a good idea for you to understand the three main reasons for the sector’s defensive attraction.

1. RENT IS PREDICTABLE; A BUSINESS’S PROFITABILITY IS NOT

Think of an ordinary listed investment like a bank or supermarket. Shareholders in BHP or ANZ Bank receive a dividend only if the business makes a profit. And the level of that dividend depends on the extent of the company’s profit. If times are good, everyone’s a winner. If not, the dividend may be cut or halted altogether. When cash flows are volatile, so too is the income paid to shareholders.

Now think of the rent these companies have to pay for the premises they occupy; the commercial offices, warehouses and retail outlets. These are essential for them to be able to operate and generate sales. And whether they’re profitable or not, BHP and ANZ must pay rent to the owners of these properties each and every month, regardless of their profitability.

For commercial property investors this is the source of the sector’s defensive strength. Rent must be paid regardless of profitability, which is why the income from property trusts can be relied upon each and every month when dividends from ordinary listed companies cannot. If sales have slowed, BHP and ANZ still need to pay the monthly rent.

2. LONG CONTRACTED LEASE TERMS PROVIDE RELIABLE INCOME

In residential markets, lease terms often run for just a year. In commercial property, they’re usually contracted over five years and it’s not uncommon for 10, 15 or even 20-year leases. In addition, rents cannot usually fall over the period of the contract.

It’s the rent collected from tenants, secured by long-term lease agreements, that delivers the distribution of relatively high, sustainable income to commercial property investors.

3. REGULAR RENTAL INCREASES PROVIDE A DEFENCE AGAINST INFLATION

In commercial property the most common approach to increase rents over the term of a lease are:

  • Annual increases linked to changes in the Consumer Price Index (CPI), the traditional measure of inflation.
  • Fixed annual increases which generally range from 2-4% p.a.
  • Some landlords utilize a combination of the above.

This is not to say that rents can’t go down at the end of a lease, but these regular reviews help mitigate against inflation making commercial property a more defensive investment.

In summary, residential property investing is more speculative than commercial property investing, where the emphasis is on the stability and reliability of the income stream.

1. Effective cash yield takes into account deductions such as: agents fees, advertising, repairs and maintenance, vacancy on renewals, insurance, cleaning/damage. Source: APN models, research and external broker reports.