What are the Key Differences between Residential & Commercial Property?
There are several key differences between residential and commercial property investments. While they do share common characteristics in that they are tangible assets, they differ widely in terms of risk, capital, income, and returns.
What is Residential Property?
Residential properties include single-family homes, townhouses, and apartments. The property owner can live in the property or can rent out space and enjoy rental income. Families and individuals typically lease residential properties. As a result, there is typically an emotional element involved in residential real estate as it involves renting individuals or families their primary place of residence.
What is Commercial Property?
Commercial property is used for non-residential activities such as hotels, office space, retail shops, industrial buildings, public facilities, etc. Similar to residential property, the owner can operate a business from the commercial property they own or lease some or all of the space to tenants. Many companies prefer to rent rather than own the property they operate their business from since the real estate is not their core business they can free up capital to invest in their core business. This makes commercial property a significant investment market. Commercial property is supported by underlying tenants who produce goods and services to generate their income. This is not usually the case with residential property which is seen as a non-productive asset.
Commercial properties refer to:
- Retail buildings
- Office buildings
- Industrial buildings
What are the Primary Differences between Investing in Residential Property vs. Investing in Commercial Property?
1. Barriers to entry
Traditionally, commercial property has made it hard for investors to access debt and even currently banks lend at lower loan to value (LTV) ratios than residential property. For investors, this means placing more equity in the project. Commercial LTV ratios track between 40-60% while banks lend up to 90% on a residential asset. However, with greater leverage comes increased risk on the borrower and greater interest costs. This high barrier to entry has kept many investors out of the commercial property market. Although companies like Jasper are providing all investors access to the once elusive sector by reducing equity minimums on high-grade institutional commercial property.
It can be argued that commercial property requires significantly more investigations before making an investment decision, which is another reason why investors are hesitant to make the jump into commercial real estate. Both sectors require investors to investigate the title, covenants, building reports and market fundamentals. However, with commercial property, additional investigation is required into seismic strength, underlying tenant covenants, operational efficiency, building services condition, outstanding warranties or consents, etc. In commercial leases, it is more common to find specific terms by which the parent company will guarantee the lease should the tenant become unable to fulfill its obligations. This is a useful protection that is not commonly found in the residential space. Investing with a manager like Jasper allows investors to leverage the knowledge of an in-house investment team, which carries out robust and thorough diligence on every property brought to market taking the headache out of commercial property investment.
Another issue that any investor will face is property management. In residential property, it is common to deal with a single tenant or household. However, in a multi-let commercial building owners may see upwards of 20 tenants. This comes with its obvious operational challenges that require experienced property managers to assist in collecting rents, instructing repairs/maintenance and ensuring a comfortable tenant experience that helps retain tenants and keep vacancies to a minimum. It is vital that investors partner with quality commercial property operators to maximise the value of their assets. On the residential side many investors will manage the assets themselves and if real estate is not their core expertise this can sometimes lead to mismanagement meaning the maximum value is not extracted from the investment.
2. Returns profile
The key driver for capital growth over the long-term is growth in rental income. Tenants of commercial property typically sign long-term contracts, with leases in excess of 10 years not uncommon. For commercial property, this is usually built into the lease with fixed and/or market rent reviews. Certain lease terms might include a mechanism that restricts the rental from going lower than the previous level (ratchet clause). It is uncommon to find this structure within residential leases which reduces income certainty for an investor in the residential space. In addition, commercial property arguably allows for more opportunities to augment rental growth through active and efficient asset management that releases value and enhances the returns on property.
Both the commercial and residential sectors are driven by supply and demand constraints. However residential rents are paid by households which means rents are tied to household incomes and over the past decade wage growth in OECD countries has been a dismal 6.3% in total since 2008. For investors, the bottom line means you can charge more rent per square meter for commercial space than residential space, resulting in a better return on your investment. On average, a commercial property will yield about 5% to 8% per year, depending on the location and supply/demand for the commercial space, and residential properties typically yield 1% to 5% per year.
3. Risk profile
In general, due to the long-term nature of commercial property leases, cash flows are much more stable and secure than those in residential property. Residential tenants typically sign much shorter leases, usually six months or one year, with break clauses that offer the option of leaving the property at short notice. This implies a higher risk profile of the underlying income stream for the investor relative to commercial property.
Unlike commercial property, the lease structure for residential property usually requires the owner to take responsibility for repairs and routine maintenance. It is common in commercial property for the majority of property management, repairs, routine maintenance to be the responsibility of the tenant, however, the level of this varies with the lease.
Both sectors have traditionally been plagued by liquidity issues, the ability for an investor to quickly get their money out of their investment. The commercial sector has responded with listed property funds and REITs (see our article on REITs here) which provide investors indirect access to commercial property and improves liquidity for participants. However, liquidity in direct commercial property remains restricted within traditional property syndicators. The advent of a secondary trading platform will significantly enhance liquidity in the direct commercial property space. Jasper currently has plans to roll out such a platform, which will give investors access to trade commercial property shares on a secondary platform. There are currently no established platforms that cater to the residential space, current investors are forced to run a campaign through a real estate agent if they are looking to exit their investment. This process can take anywhere from 30 to 50 days to complete.
4. Valuation methods
The residential market can present rather irrational valuations, driven by sentiment of owner-occupiers more than that of investors. Further evaluations are driven by comparable properties in the area which is often outside the control of investors. This can lead to greater volatility, with the residential market arguably more immediately exposed to movements outside one's control such as changes in interest rates. Movements in interest rates affect different sectors of the commercial market with varying impact and over varying timescales. In commercial property, valuations are much more determined by fundamentals - namely, the current value of future income streams.
When market conditions are stable and a property is managed correctly, both residential and commercial can be strong investment opportunities. Commercial property typically tends to come with higher risk, but higher reward. Potential investors should consider commercial and residential property sectors separately, or their investment strategy could become unbalanced.
For those interested in investing in commercial real estate without the hassle of managing a physical property, Jasper offers investors the opportunity to own institutional-grade commercial real estate using a fully digitised onboarding, accreditation, and subscription process. Additionally, Jasper plans to provide a secondary market, allowing investors the potential to sell their equity to other investors. This will give investors enhanced liquidity in a traditionally illiquid asset class.
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CIO & Director, Jasper
Published December 1st, 2019