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Is Commercial Real Estate a Better Investment than Residential Real Estate?

Is Commercial Real Estate a Better Investment than Residential Real Estate? Everyone in society seems to have an opinion on the property cycle and currently whether prices are dropping, stabilising or increasing.  It seems that this topic is often broached at casual meetings with everyone from your neighbour to your doctor.

It’s a completely different story, however when the conversation shifts towards commercial property.  During the conversation if you ask about commercial property most people have no idea.  This is a shame as the commercial property market is full of opportunities and typically promises greater returns without the usual day-to-day headaches of residential property management and maintenance.

To start with let’s look at what is a ‘Commercial Property’.  Some examples include:

  • Retail buildings
  • Office buildings
  • Warehouses
  • Industrial buildings
  • ‘Mixed use’ which could be a combination of retail, office and residential apartments

As with every investment there are pro’s and con’s in investing in commercial rather than residential, let’s look at some of these.

Lease Length

Generally commercial properties have much longer lease periods than residential properties.  These lease periods play a crucial role in determining their value.  You may have heard of the term ‘WALE’ which is short for ‘Weighted Average Lease Expiry’ and this plays a vital role if the asset is going to be sold.  The reason for this is it’s much harder to replace a commercial tenant than a residential one, partly because there are less tenants looking for commercial properties and they have linger leases than residential properties, so less turnover and moving.

Vacancy Periods

Unfortunately, due to the above reasons commercial properties tend to stay vacant for longer than the average 2-3 weeks of a residential one.  This means that the owner would need to cover the outgoings and expenses without any rent coming in — for potentially 6-12 months.

Lease Terms

Standard Residential Tenancy Agreements don’t allow for much flexibility, so terms of a lease don’t vary too much. However, with almost every term of a commercial lease up for negotiation the initial stages of discussing the agreement needs to be carefully considered.  Therefore, having an experienced property manager on your hands makes a huge difference when negotiating these factors, which in-turn have a material effect on your valuation.

Annual Rent Increases

Most commercial leases have an annual rent increase build into the lease.  Presently most new leases have this set at 3-4% rather than CPI increases which was previously the norm.  This is potentially much higher than the level of inflation which works in the owner’s favour.

Expenses

Most larger commercial tenant’s sign ‘Net’ leases rather than ‘Gross’ leases.  This means that as well as rent the tenant reimburses the owner for outgoings. These could include council rates, water rates, strata levies, insurance, land tax, maintenance, repairs and even the management fees charged by the agent.  If you flip the coin back to residential property, the only one you can pass on is water usage and that is if the property is separately metered and has had a water efficiency audit carried out.

Tenant Behaviour

Small business owners generally take pride in their businesses and want to present themselves this way.  This is especially important for retail and office tenants as they have a vested interest in maintaining their store or office, because if they don’t it will affect their business.  Due to this, commercial owners and tenants interests are aligned, which helps the owner maintain and even improve the value of the property which ultimately increases the return of their investment.

Terms of Finance

Because commercial investment is deemed to be a higher risk than residential property the banks generally require a higher deposit. This is one of the main reasons that investors shy away from commercial properties. As always, any investment needs to be carefully considered.  If you are planning to move into the market either residentially or commercially, I would love to have a chat and we can help way up the pro’s and con’s for your asset as every situation is different.

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