Commercial versus residential for your first property investment

From WikiProperty

When you get to the point where your mortgage on your home is either under control, or paid off, many people think of buying a 'rental' flat or house. This springs to mind because we have learnt that property is always a good investment, mostly appreciating, and it is 'solid' not like those paper certificates that represent shares. (This is a gross generalisation and is another area of discussion altogether). Certainly property is a good initial investment which can be added too in the future, to form a balanced investment portfolio.

People usually think firstly of a residential property investment because conceptually it is the same as the home they live in, and they know about renting residential properties as they used to rent when they left home. Additionally, they are likely to know someone else who has been able to buy a 'rental' and can discuss it with them. (It's much harder to find someone who has a small commercial investment). The starting price to get into a residential investment is generally lower so it is easier as a first investment, although there are some lower priced commercial investments. More importantly, it is easier to borrow a higher percentage of the purchase price on a residential property than commercial property. While it is common to borrow 90% of a residential investment around 70% is more usual for a commercial investment. However, depending on your financial circumstances, the balance of the deposit could be raised against your home. Another advantage with a residential property investment is that, in hard times, you should be still able to get a tenant providing you are prepared to drop the rent to meet the market. This is not always the case with commercial as the right type of tenant may just not be available.

The above are all excellent reasons for buying a residential investment, however, there are also advantages with buying a commercial property investment. One of these is that usually you can hope for a higher % return on investment (ROI) (calculated by dividing the rental income by the purchase price and multiplying by 100) from a commercial property; residential ROI % is usually 4-7% whereas commercial is 9-12%. With a commercial property there usually is a formal lease which offers longer term security as the tenant is committed to renting the property for the full length of the term. The times for rent reviews are set and often there are personal guarantees given by the lessees (for liability of the rent) hereby encouraging them to respect the terms of the lease. Additionally, under the lease, it is usual for the tenants to pay rates, insurance, legal fees for drawing up the lease and any body corporate fees, which enhances the ROI.

With a commercial investment you are not likely to have a lot of minor repairs as these are covered by the tenant, but you will have the usual exterior repairs. In a commercial tenancy the tenant usually covers interior maintenance of the building and the landlord maintains the exterior, hence you are not involved in redecorating between tenants. As the exterior construction of a commercial building is mostly functional rather than decorative the maintenance tends to be less. Overall, the time spent on managing a commercial property will be less than that involved in a similar sized residential investment. However, it will take more time and research to buy a suitable commercial than residential investment. In my experience this is the vital part of investing in commercial property. It must always be remembered that while residential property is valued according to the market, commercial property value is more dependant on the quality of the tenant and the rental they pay. Therefore, even in a poor market your commercial property may still be appreciating and saleable. Nevertheless, the focus of commercial property ownership, especially for the first time investor, is more prudent to be on creating cash flow rather than making capital gains. It takes considerably more experience to be a trader in the commercial market.

Most investors tend to assume that they would not have enough money to be able to get into a commercial investment, and this may be true as starting prices are higher, and the deposit required is higher than for residential. However, if looking at a long term investment, because of the higher ROI and probably a better more reliable tenant, it can be worth persevering to get a commercial investment underway.

The following is a summarised list of the advantages of disadvantages for a 1st time investor on buying a residential or commercial property investment. The list is by no means exhaustive and if you have any comments I would love to have feedback in the discussion forums.

Residential Property Investment:

Advantages:

• Lower deposit required for a mortgage (10%?).
• Can usually get a tenant even if the market is soft by lowering the rent.
• Familiar type of building/construction.
• Familiar type of rental agreement/situation.
• Tend to know someone with a residential investment so can discuss it.

Disadvantages:

• Lower ROI.
• Tenants tend to be more transient.
• Responsible for all interior and exterior maintenance of building.

Commercial Property Investment:

Advantages:

• Higher ROI.
• Longer term security because of a formal lease eg. personal guarantees, fixed lease period, scheduled rent reviews.
• The tenant usually covers rates, insurance, body corporate expenses.
• Usually more continuity of tenant and notice of change of a tenant.
• Usually only responsible for exterior maintenance as tenant responsible for interior.
• Construction is usually functional so lower maintenance.
• Less time involved in management, little problems usually handled by tenant.

Disadvantages:

• Higher deposit required to get a mortgage (30%?).
• Higher legal fees for purchase.
• More time/effort/research/knowledge required for purchase.
• May be harder to re rent if the market is soft.
• Unlikely to know anyone with a commercial property investment to discuss it with.

In summary, it requires a steep learning curve and a degree of bravery to make your first property investment commercial, rather than residential, but for us personally it certainly has paid off. So why don't you use the input you can gain from this site and other sources to give you the confidence to try commercial property investing.

Many of the issues I mention in this brief report may require expansion for you, and all are open to discussion so feel free to discuss with me and other participants.

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