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Should you invest in residential or commercial property?

What are the pros and cons of investing in residential vs commercial property? (Source: Getty)

Property is a huge asset class.

From your primary place of residence to an investment unit, to a neighbourhood commercial space to a shopping centre, not all property investments are the same.

 And the costs involved in owning and operating property vary, as do the investment returns.

Moving from the residential sector into commercial can be an enticing proposition.

Frank Lowy made his start with a small commercial tenancy, before building to small neighbourhood precincts. He then went on to found and captain the global Westfield empire of major retail precincts.

But is it as simple as moving from one sector to another? 

And what are the pros and cons of each of the asset classes?

Where are you on your investment journey?

Most investors start with residential property because they’re comfortable with the concept of owning a home or apartment and renting it out. 

It is easy to understand – we all need to live somewhere. 

We are familiar with the renting process and handing over the day to day management to a property manager.

However, residential real estate is a high growth relatively low-yield investment

After all expenses, your net yield may be less than 3%. 

But when you consider the capital growth you’ll achieve from a well located ‘investment grade” property, the overall returns are very good, especially in today’s low interest rate environment.

And as this capital growth is not taxed unless you sell your property (and why would you do that?)  this enables you to reinvest your capital to generate higher compounding returns.

 On the other hand, rental income is taxed, leaving less to be reinvested.

This means for investors in the asset accumulation stage of their journey, the more capital growth you achieve (even at the cost of lower rental income) the more wealth you will accumulate in the long term.

When investors eventually transition to the cash flow stage of their journey, adding higher yielding commercial properties to their portfolio makes sense.

Can’t I just buy high yielding residential investments?

Yes, you can! 

CoreLogic found the best-yielding area in Australia was the Queensland mining town of Blackwater, where there was an average return of 11.8 per cent for a median price house worth $120,000.

But I wouldn’t invest in a mining town – would you?

I’d rather put my money into a well-located property in a gentrifying inner or middle ring suburb of our three big capital cities where there are multiple growth drivers including economic growth, jobs growth, population growth and infrastructure spending.

And I would look for a suburb which has a large percentage of owner occupies who are earning higher wages so that they can afford to and prepared to buy houses in this location. 

Sure these locations will provide lower rental yields, but they will have low vacancy rates, more stability of property values and stronger long-term capital growth potential.

What about commercial property investments?

Just like residential real estate, not all commercial property makes good investment, and there are a variety of options including offices, shops or warehouses.

Some of the benefits of owning commercial real estate include stronger returns; longer leases (from 3 to 5 years); regular rental increases to the CPI; substantial depreciation allowances and your tenant will pay many of the outgoings.

That’s good so far, doesn’t it?

However successful commercial property investment requires an understanding of the complex economic and market factors at work; the unique financing requirements, different leasing arrangements and a good grasp of the potential risks.

You will also need to understand how prevailing interest rates, economic and political factors affect the value of commercial properties. 

For example, in the current low interest rate environment investors chasing yield are pushing up the value of commercial properties, but when interest rates eventually rise, the opposite will happen and values will fall.

It should come as no surprise that the entry level to purchase a commercial property is usually higher than that for residential. 

Partly because the price of a good commercial investment is substantial and partly because you require a larger deposit as banks won’t lend you as high a proportion of your property compared to residential real estate

One of the things I like about commercial property is that there is the opportunity to add value.

You can renovate, upgrade, subdivide, improve the appearance of your property, renegotiate the lease or obtain permission for redevelopment or change of use to residential apartments.

Downsides of commercial investments

One of the challenges in the current economic environment is changing face of retailing and use of office space brought on by Coronavirus. 

These commercial property sectors would be best avoided by beginners. On the other hand, demand for industrial properties used for warehousing looks set to boom.   

However one challenge for beginning commercial investors is the scarcity of information. 

There’s nowhere near the plethora of information regarding residential real estate, meaning it’s hard to get an understanding of current returns, rentals and capital growth rates.

And when commercial properties become vacant, they can remain so for a long, long time. 

How often have you gone past that shop down the road that still has a for lease sign on it?

That’s why the value of a commercial investment relies heavily on the strength of your tenant and the security of your lease.

And when the time comes to sell your property, overall the time taken to sell is longer than residential property and a vacant property is often worth considerably less than a well leased property.

The bottom line:

Clearly there are advantages for both commercial and residential properties and to decide which investment would be best for you it’s important to understand your investment goals and strategy and the stage you are at along your investment journey.

Michael Yardney is a director of Metropole Property Strategists, which creates wealth for its clients through independent, unbiased property advice and advocacy. He is a best-selling author, one of Australia's leading experts in wealth creation through property and writes the Property Update blog.

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