Thinking of investing in commercial property? Read this first.
Like many hot button issues in real estate investing, the debate on whether it’s better to invest in residential over commercial continues to divide investors.
Proponents of investing in residential say it’s the least risky option, while those who are in favour of commercial would argue that commercial is safer due to its cash flow potential.
Smart investors of course don’t choose between the two: They look at both to see how it may fit their portfolio.
Property investment: Commercial or residential?
The case for investing in commercial property now
Higher returns on investment
The average rental return for residential properties across Australia’s capital cities is 3.6% according to CoreLogic RP Data. In contrast, it’s not uncommon to get anywhere between 8% and 12% gross rental yield for commercial properties.
While a residential tenancy can turn over every six to 12 months, a commercial tenancy can be anywhere between three and 10 years. Tenants also tend to stay longer especially when they’ve invested some capital customising the premises.
No rates and other outgoings
Unlike residential properties where landlords are liable for paying rates, such as council, water and body corporate, commercial tenants pay these outgoings for you.
Commercial properties are generally lower priced compared to residential properties so you need a smaller capital outlay. For example, a car park can cost as little as $80,000 as opposed to $400,000 for a small bed-sitter. Investing in commercial property could be a great way to get into the market sooner compared to saving for a residential property investment.
What are the risks?
While commercial property looks attractive on paper, there are potential risks you need to be aware of before investing.
Commercial properties are sensitive to economic conditions
When the economy is strong, businesses flourish and demand for commercial properties generally rises. But when there’s an economic downturn, demand for commercial premises usually falls.
It takes longer to find a tenant once it becomes vacant
While commercial properties attract long-term leases of three to five years or more, it can take longer to find a tenant. It’s not uncommon for commercial properties to have long vacancies, which means you will need to cover all the cost during this period.
It’s vulnerable to changes in supply
Changes in supply conditions can create potential problems for investors. An increase in new property coming on the market in the same area creates a threat to existing tenancies as tenants may look to upgrade or expand. Strong supply can also reduce potential yields.
Changes in infrastructure in the area can be detrimental
While major infrastructure changes in the area can attract commercial investments there, it can also lure tenants away from existing areas and older commercial premises. This could result in your property becoming vacant.
Values can drop sharply
The value of commercial properties closely correlates with the lease on the property. If a commercial property becomes vacant, or the lease is about to expire, the value of the property would generally be expected to fall. In contrast, any price falls associated with residential properties are generally less dramatic and usually happen progressively over a longer period of time.
So, should you buy commercial or residential?
It depends where you are now in your portfolio. If you’re looking to diversify and want a cash flow injection, a well-located commercial property might be a good addition. Just make sure you do thorough due diligence and understand the risks involved.