Wednesday 5 June 2013

Residential Vs Commercial Property

The intention of this post is not really to prove that residential property investment is better than commercial or vice versa, it's rather to provide an independent comparison between the two. Both methods of investment can be highly profitable if carried out sensibly, but both are very different, and as such might suit different types of investor.
Firstly It must be noted that commercial property is inherently more expensive than residential; to build a well diversified commercial property portfolio directly, you would need a few million pounds spare. Luckily smaller investors can still get involved through collective investment schemes/funds such as the F&C commercial property trust, that I have mentioned in recent posts and have some personal exposure to.

Commercial properties can be harder to value due to the uniqueness of the buildings involved. When a residential property is for sale you can generally find out what a similar property sold for recently in the same area, this is not always possible for commercial property, so extra care and professional advice is needed. A good agent can prove invaluable. This issue is obviously avoided by taking the more passive approach and investing in funds, as you will be paying for professional experience via the fund management fees.

Commercial property can be held directly in a pension fund, whereas residential cannot, this benefit could be very significant for investors wishing to capitalize on the generous tax treatment of pension plans.

Letting time-frames vary considerably between commercial and residential. A residential tenancy agreement usually lasts a year, whereas a commercial lease usually lasts 5+ years. The shorter lease agreements on a residential property can lead to larger void periods, thus negatively affecting returns. However, although void periods on commercial property are shorter on aggregate, it can be quite difficult to find new tenants, and in a subdued climate (such as we are currently) rent free periods are sometimes offered as an enticement, which obviously affect net return.

With residential property, the responsibility of repairs and maintenance falls on the landlord. These costs are often overlooked, and can absorb much of the rental income (30% in some cases). With commercial property the tenant is usually responsible, thus saving the landlord time and expense. One exception of this is office blocks, where some tenants do expect periodic upgrades to the premises at the expense of the landlord.

Commercial rents are generally higher than residential. Between the period 2002-2007 commercial rental yields were 50% higher than that of residential property. I would say that this still holds true now with residential yielding about 5% and commercial around 7.5%
On the flip side of the coin, capital growth has been much higher in the residential market, which has led to superior total returns over a prolonged period.   

Over the 30 years between 1981 and 2011, residential property has proved the better investment, returning an average total annual growth of 11.2% p.a. Commercial returns were significantly lower at 9.1% p.a.
It could be argued that government policy has given residential property a helping hand over this period. The Thatcher government implemented policies that incentivised home-ownership, and every government since has tried to capitalize on the 'feel good' factor caused by rising house prices. Have these policies been pushed to the brink? Will residential continue to outperform?

What is clear is that commercial property has taken a considerable beating of late. While residential property fell on average about 15-25% during the credit crisis, the commercial property market plummeted 40-50%, and hasn't made much progress since.
There are many reasons for this; the high street is undergoing a structural change as more business is being done on the internet via remote locations. Business rates are also high and making things more difficult for businesses in the current low growth environment. Also there are an increasing amount of people choosing to work from home which obviously decreases demand for commercial floor space.
All these factors paint a bleak picture for commercial, yet because of them we are seeing the lowest asking prices for many years, and double digit rental yields are common place for those willing to dabble in the more risky end of the market place.  The contrarian in me thinks that commercial could be the more profitable choice over the next decade or so.