Thinking outside the box – Commercial property vs residential

April 4, 2016

Residential property tends to dominate the news and is a topic of choice for Australians. With skyrocketing prices, social concerns regarding affordability, speculation of a looming bust, the eleventh series of “The Block”…you would be forgiven for thinking that the only type of property is ‘residential’, but did you know that commercial property in Australia is worth a staggering $700 billion (CoreLogic RP Data, October 2015). 

For many, owning your own home or buying an investment property and leveraging off Australia’s attractive negative gearing laws is an appealing wealth creation strategy. However, there are compelling reasons for investors to look beyond the residential home and broaden their investment portfolio to include commercial property.

Certain income vs uncertain growth

Commercial property is an income investment, known for its high yields and steady long term capital growth. These high yields (which comprise the main component of the total return) are usually backed by commercial rent agreements which are locked in for five or more years, creating a greater level of certainty on short to medium term returns. Most commercial leases have contracted rent reviews (generally meaning that the rent cannot drop) directly linked to CPI, fixed rates or market based reviews.

Conversely, residential property is generally considered a high growth and low yielding asset. The potential for capital growth can be high, but ‘punting’ on potential growth returns from property can be fraught with danger, especially when you consider variables like interest rate hikes and changes to foreign investment laws. The low initial yield that Australian residential property investors accept presumes an inversely high level of capital growth. But you do run the danger of buying at the wrong time and experiencing low yield and low growth.

A side by side comparison

 

Residential property

Commercial property

Effective cash yield

2-4% per annum*

Around 6-7% per annum

Capital growth

Highly variable

Steady, low capital growth

Property types

Houses

Apartments

Flats

Townhouses

Office

Retail

Industrial

Healthcare

Retirement living

Leisure parks

Hotels

Leases

Short term (typically one year)

Long term (typically 5+ years)

Rental reviews

Upon lease renewal, determined by local market conditions.

Most lease contracts have locked in rent reviews directly linked to fixed rates or CPI.

Tenants

Individuals

Businesses, ASX listed corporations, multinational companies and government bodies.

Legal protection

The Residential Tenancy Act favours the tenant.

Balanced legislation between landlord and tenant. Commercial tenancy agreements are dealt with as business contracts and are negotiated at arm’s length between the parties.

Property costs

The tenant is required to maintain good order. Costs are largely borne by the landlord.

Most leases will provide for outgoings to be paid by the tenant and typically include: council rates, water rates, land tax, insurance, strata levies and property management fees.

Tenants are required to ‘make good’ conditions factored into the lease. Majority of costs are borne by the tenant.

* Core Logic RP Data Home Value Index. Effective cash yield takes into account deductions such as: agents fees, advertising, repairs and maintenance, vacancy on renewals, insurance, cleaning/damage.

Commercial property is attractively priced

Whilst the Australian residential market is considered over valued by many industry experts, our valuation analysts shows that Australian Real Estate Investment Trusts (AREITs) are currently attractively priced. AREITs, formerly known as Listed Property Trusts are made up of a portfolio of property assets listed on the ASX that allow private investors to own a portfolio of large properties that would not normally be accessible to individual investors due to their value and size. 

A key metric utilised in our AREIT valuation process includes analysis of a trust’s Net Asset Value (NAV), which indicates that the market is currently trading at a discount of around 8 per cent and suggests material upside potential. AREITs are currently yielding in the range of 5.5-8.5 per cent.

Income. Diversification. Liquidity

A well-managed AREIT portfolio can offer investors an ideal way to access high quality commercial property and enjoy greater diversification in their portfolio. Not only is the risk/reward trade-off superior due to the lower reliance on capital growth, but the lower ongoing costs makes exposure to commercial real estate more accessible and attractive than a residential property investment.

If you would like to learn more about commercial property investments and AREITs, speak with your Leenane Templeton financial planner on 02 4926 2300.

Source: APN Property Group

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