Investing in property? How to choose between residential and commercial property

Recently, I have noticed that many friends know little about commercial property investment and tend to approach it with the mindset they would use when buying residential property. Today, let us briefly consider several aspects of the differences between residential and commercial property investment.

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Commercial property: greater variety

Residential property includes apartments, houses, terraced houses, townhouses, units and more.

Commercial property includes retail premises, hospitality premises, hotels, warehouses, industrial premises, offices, car parks, wineries, farms, large development sites and more. 

Residential property categories are relatively straightforward, while commercial property covers many different types. Commercial property investment therefore requires considerable specialist knowledge.

Because less knowledge is needed to get started, many investors begin with residential property.

Residential property: landlords bear more costs

Tenants in residential investment properties only need to pay rent and their own water, electricity and internet costs. Other expenses, including council rates, insurance, repairs, management fees and even the monthly water meter charge, are paid by the landlord;

For commercial property, tenants must cover almost all costs, including council rates, insurance, repairs and scheduled maintenance, management fees, valuations, legal fees and even fit-out costs. They must also restore the property to its original condition when the lease ends.

Commercial property: higher rental yields

Residential property generally yields around 2%. In recent years, residential rents have grown more slowly than house prices, while holding costs such as council rates, insurance, repairs and management fees have continued to rise. Government policies sometimes also limit how frequently rents can increase, such as the recent 6-month rent freeze. This has created a situation where higher property values mean lower yields. 

Commercial property generally yields around 5%–6%. Higher commercial property values are matched by higher rents: the relationship is proportional.

Unlike residential property, all holding costs are paid by the tenant. Commercial rents generally increase annually in line with CPI or inflation, and regular market valuations are required to adjust the rent.

Commercial property: more complex valuations

Residential property valuations mainly use nearby property sales as a reference. Commercial property is valued mainly on rental yield.

If annual rent is NZ$50,000, and the yield for that type of property is, for example, 5.5%, dividing the NZ$50,000 rent by the 5.5% yield gives an approximate commercial property value of NZ$910,000.

But this price is not absolute. For example, with the economy currently struggling, if the property is expected to have no tenant for the next year or two, the buyer and seller can negotiate further on price. 

Apart from luxury homes, the vast majority of residential properties in New Zealand cost less than NZ$2,000,000. Commercial property prices can range from NZ$80,000 for a car parking space to NZ$200,000 for a small warehouse, through to tens or even hundreds of millions of dollars for large office buildings.

Capital growth potential is difficult to assess

At the lower and middle price points, residential property may appreciate much faster than commercial property. For high-value commercial properties, however, capital growth potential can sometimes far exceed that of residential property.

There are many types of commercial property, each with different capital growth potential.

Many commercial properties, particularly motels and industrial or agricultural properties, occupy large sites. Zoning changes can therefore create substantial subdivision potential. Capital gains in these circumstances are certainly beyond what residential property can offer.

Easier to find tenants versus longer leases

Most residential tenancies usually begin with a six-month or one-year term, with an average tenancy of two years and relatively high tenant turnover.

An advantage of residential property is that tenants are relatively easy to find: an advertisement can produce results quickly.

Commercial tenants are harder to find than residential tenants, but leases average 3–9 years. For properties such as hotels and motels, they can even run for 25–30 years. Once you successfully find a tenant, you therefore need not worry for quite a few years.

Commercial property: a more complex buying process

Buying residential property is relatively straightforward. Consider location, building materials and school zones, refer to nearby sales, and visit a few open homes based on your requirements and budget, and the purchase can be easily sorted. 

By comparison, commercial property comes in many forms and involves many areas of knowledge. Due diligence is generally required before buying, covering the property’s title, previous financial statements, current rent, market value, lease terms, the condition of the property itself (does it leak? What is its seismic rating?), the nature of the commercial area, and whether the authorities have any near-term plans to change the area. Lawyers, accountants and sometimes other experts therefore need to be involved. The buying process is far more complex than for residential property, and costs are much higher. 

Residential property requires annual tax returns, and may also require tax planning before purchase and financial statements after purchase.

Commercial property also requires GST registration and returns. It is generally held by a company or trust, requires annual financial statements, and involves regularly invoicing tenants. Its tax affairs are therefore more complex than those of residential property.

Commercial property: higher vacancy risk

During this coronavirus pandemic, many apartments mainly serving tourists and international students have lost their tenants.

However, compared with the essential demand for residential rentals, commercial property carries a far higher vacancy risk, particularly when the economy is weak. This can also cause cash flow problems, as commercial property holding costs, including loan interest, are far higher than those of residential property.

But we have also seen that essential businesses were unaffected during the Level 4 lockdown.

Investing in commercial properties occupied by essential businesses is therefore relatively safe.

Residential property: easier to turn into cash

Differences in demand mean residential property is far easier and quicker to turn into cash than commercial property.

Commercial property: higher deposits and interest rates

With the recent easing of LVR restrictions, residential property loans can cover up to 8 tenths of the property’s value, or even more. Investors must, of course, have a stable source of income and security acceptable to the bank. 

Commercial property loans can cover up to 6 tenths of the property’s value, so investors need a sufficient deposit. For small commercial properties, banks assess applications in a similar way to residential property loans, but also consider whether a long-term lease is in place. Interest rates are usually at least 1 percentage point higher than residential property rates.

Commercial property: greater control over tenants

In residential letting, the contract is between a property owner and someone without a property. When problems arise, tenants are often regarded as the more vulnerable party and given greater consideration. We therefore often hear of tenants deliberately taking advantage of landlords by not paying rent, refusing to leave or causing damage. Even if tenants leave a house badly damaged, the landlord’s only recourse is to deduct their 3 weeks’ bond, so landlords must be prepared to pay out of their own pockets. 

Commercial letting is business to business. Leasing is the owner’s business, and the tenant is also a business operator, putting the parties on relatively equal terms. A lease agreement is signed beforehand, making it easier to resolve disputes through reasoned discussion. Commercial landlords also investigate prospective tenants and require an advance bond or bank guarantee, as well as a personal guarantee. Because tenants are also running businesses, they tend to take better care of the property and pay repair and maintenance costs. Commercial property insurance paid for by the tenant provides comprehensive cover and greater protection for the landlord.

Commercial property: simpler, less stressful disaster claims

Insurance claims for many residential properties following natural disasters, such as volcanic eruptions and earthquakes, are extremely complex and slow. Even 9 years after the Christchurch earthquake, some affected homeowners have still not received insurance payouts. 

By comparison, most commercial properties have cover for earthquakes and other natural disasters, even including loss of income. Claims are simpler and less stressful than residential claims.

Commercial property: more favourable tax policies

Negative gearing for residential investment properties has been abolished through residential rental loss ring-fencing. Since 1 April 2019, residential investment losses can no longer be offset against the owner’s other income.

There is also the bright-line test: residential investment properties bought and sold within 5 years are subject to tax, and residential property cannot be depreciated. 

Commercial property is unaffected by the negative gearing restrictions or bright-line test just mentioned. Because of the coronavirus pandemic, depreciation can be claimed on commercial property from 1 April 2020.

For example, a commercial property worth NZ$2,000,000 has annual depreciation of NZ$40,000. If held by a company, this is equivalent to saving NZ$12,000 in company income tax in the first year.

Residential property: overseas buyers cannot purchase

New migrants and overseas buyers can currently purchase commercial property directly, but overseas buyers cannot buy residential property in New Zealand.

Residential property: more policy restrictions. Politically, housing prices are a matter of public wellbeing, so they are always a focus of voter debate and a headache for political parties.

Whether the economy is doing well or badly, residential investment is always the easiest target for whichever party is in government.

Over the past 10 years, various policies targeting residential investment have been introduced: ending depreciation on residential property; introducing the bright-line test taxing residential investment properties bought and sold within two years; banning overseas buyers from purchasing homes; extending the bright-line period from 2 years to 5 years; and now abolishing negative gearing. The prospect of a capital gains tax applying only to residential property also remains a sword hanging over taxpayers’ heads.

Commercial property, by contrast, attracts very little political controversy because it does not affect people’s basic living needs. At most, the debate concerns someone buying a few farms or similar matters.

Commercial property also provides vital support for local business and the economy, so the Government will not suppress it through policy and may even encourage investment.

I hope this discussion of the many differences between residential and commercial property will help inform your next investment. For first-time investors, residential property is a relatively simple and inexpensive option.

If you have been a seasoned property investor for many years, consider commercial property. After all, all the world’s wealthy people who made their fortunes in property, including President Trump, have done so through commercial property.