Company news
26 Nov 15

Thinking outside the (residential) box

Commercial property vs residential property

Residential property tends to dominate the news and is a favourite topic of choice for Australians. With skyrocketing prices, social concerns regarding affordability, speculation of a looming bust, the eleventh series of “The Block”… 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 attractive wealth creating 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.

Table 1: A side by side comparison

Residential propertyCommercial Property
Effective cash yield2-4% per annum*Around 6-7% per annum
Capital growthHighly variableSteady, low capital growth
Property typesHouses
Retirement living
Leisure parks
LeasesShort term (typically one year)Long term (typically 5+ years)
Rental reviewsUpon lease renewal, determined by local market conditionsMost lease contracts have locked in rent reviews directly linked to fixed rates or CPI.
TenantsIndividualsBusinesses, ASX listed corporations, multinational companies and government bodies.
Legal protection The Residential Tenancy Act favours the tenantBalanced 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 costsThe 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 analysis 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 and listed on the ASX. They 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.