What are the differences between commercial vs residential real estate?
Commercial real estate is made up of properties that are for non-residential use and consist of many different sub sectors such as office, retail or industrial assets.
Investing in commercial properties can be so complex and there are even nuances within the sub sectors in the industry. For those that own investment properties this guide aims to take residential investment property as a point of reference to highlight the key differences between investing in commercial vs residential properties.
One characteristic of commercial investments are that they are known to be more income driven as represented by the cap rates. Residential properties trade at a much tighter yield than commercial leases which result in a majority of investment returns come in form of capital gains. This is the primary driver of the negative gearing phenomumon commonly seen in residential investing.
Commercial properties are positive gearing assets which the income more than offset the interest on the loan. Capital gains still play an important role in the long return but a much lower proportions.
How tenants see differences
Residential leases are in most instances simple and almost standardised with limited room to negotiate aside from the rent. Commercial leases whilst are seen as long follow market convention but the key commercial terms outlined below are negotiated lease by lease.
Residential leases are designed to be readable by those with no legal training while commercial leases are drafted by lawyers representing the landlord and tenant.
Lease Type – Net vs Gross Leases
Residential leases are gross leases where the tenant is obligation to provide a single payment to the landlord as part of the lease and the landlord is responsible for the management and operating costs. This is common in commercial leases but there are in some instances where the lease is a Net lease. This means the tenant will pay the rent and outgoings which is made up of the operating costs of the building such as cleaning, reparis & maintenance, landtax and rates.
Unlike residential leases which is typically for a term of 12 months, commercial leases are signed for multiple years. In most instances business need certainty and will commit for longer term. However there is nothing stopping the tenant to sign shorter leases but because it is not in the landlords interest it usually won’t considered.
For example retail leases are almost always 5 years as they are governed under the retail leasing act while office leases are usually 5 years but can be longer or shorter depending on needs of the tenant and if the landlord is open to shorter lease. As a rule of thumb unless a site is a future development opportunity commercial landlords will always prefer longer leases.
This is how the listed REITs are able to provide stable income as their portfolio are made up of assets with long term leases commonly referred to as WALE.
Because the lease term cover multiple years, leases undergo annual fixed review which is agreed upfront between the landlord and tenant. This is a step up in the rent payments at fixed % such as 3% per annum. There is also a market review mechanism in which at fixed periods (say 5 years), the rent will reset to the prevailing market rent if the space were offered to someone else.
Tenants will received a percentage of their total rent for the lease as incentive from the landlord. This is usually a material number for office leases depending on market conditions can go as high as 20% to 30% of the total rent. Tenant incentives can come in the form of rent free periods or landlord contribution to fitouts. During periods of slow market, landlords will increase incentive to reduce vacancy in their buildings.
There are a number of similarities in insurance coverages however the key differences is no insurer will offer rent loss cover in commercial property. This is because rental income for businesses are almost based on the credit of the tenant which require individual underwriting tenant by tenant basis.
Differences in property financing
Not all real estate is created equal and this is certainly true between financing commercial credit and residential properties. Underwriting standards and criteria for a loan against commercial properties is vastly different to residential investment lending.
The financing process can be complicated for even regular investors hence a reliance on commercial finance brokers to navigate the issue can be quite common however banks mostly prefer to deal with the borrower directly.
As result of the recent tightening of lending standards by the major Australian banks, this has drove the growth in the non-bank lender space as evidence by the growth of listed debt funds on the ASX.
It is important for those that are looking to invest in commercial real estate directly to understand the differences in borrowing costs, loan covenants and structure before making the plunge.
We have highlighted some key differentiating factors:
Commercial Loan Interest Rates: The rates are typically higher than cost of residential investment loans due to perceived higher risk. This is because depending on the asset, it can take longer to find a tenant for commercial properties such as retail, warehouse or office than for residential properties.
Collateral or Security Requirement: Some lenders have lower rates as they allow cross collateralize of borrowers home as well as the primary commercial asset. Hence a lower rate can be achieved by reducing the LVR by using additional collateral. Having a lease on the property is critical in securing a competitive loan rate. Costs and difficulty in finding finance increase considerably if the space is vacant.
Loan to Value Ratio Range: It is quite common to see the bank and non bank lenders to issue residential loans up to 90% of property value (with lenders mortgage insurance). Loans for commercial property are more conservative where the limit for the LVR usually tapers out after 60%. Also there are no mortgage lender insurance.
Payment structures: It is standard for commercial loans to be interest only. Some products can be amortizing which means a portion of the loan is repaid with every payment and there are no offset accounts.
Loan Terms: Whereby typical residential mortgages can be 25 or 30 years. The terms of commercial mortgage loans are much shorter which typically span 3 or 5 years. Longer term can be achieved with non-bank lenders. This is a double edge sword as the borrower will have the opportunity to take the loan to market to find a more competitive product at the loan maturity as well.
Upfront Costs: There are much more upfront cost verses residential mortgages due to involvement of various parties. This include legal fees on the loan, valuation fees for a valuation the bank would require as part of the financing process, stamp duty on the mortgage or loan as well as or larger sites a building report.
Ongoing Costs: There are potential additional ongoing costs such as line fees, account fees and draw down fees in some products. Theses fees does not have to be material however it is also something to be aware of.