Residential vs Commercial which Investment is a Better Option

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Real estate investing uses real estate properties as an investment vehicle and gains profit through a variety of methods. It can be as simple as owning real estate, collecting cash flow in rental income, and selling the asset for a higher price due to appreciation. There are major benefits of investing in real estate like owning a property, tax savings, rental income, etc. It is also not as volatile as the equity markets. These have made real estate investments quite popular. Real estate assets are typically expensive, and investors will generally not pay the entire amount of the purchase price of a property in cash. Usually, a large portion of the purchase price will be financed using some sort of financial instrument or debt such as a mortgage loan collateralized by the property itself. The amount of the purchase price financed by debt is referred to as leverage. The amount financed by the investor’s own capital, through cash or other asset transfers, is referred to as equity.

Some real estate investment organizations, such as real estate investment trusts (REITs) and some pension funds and hedge funds, have large enough capital reserves and investment strategies to allow 100% equity in the properties that they purchase. This minimizes the risk which comes from leverage but also limits potential ROI. By leveraging the purchase of an investment property, the required periodic payments to service the debt create an ongoing (and sometimes large) negative cash flow beginning from the time of purchase. This is sometimes referred to as the carry cost or “carry” of the investment. To be successful, real estate investors must manage their cash flows to create enough positive income from the property to at least offset the carry costs.

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What is Residential Property

Residential projects involve the construction of houses, apartment buildings, and even larger multistory high rise buildings. Depending upon what the actual project entails, some residential projects can take on some commercial project characteristics. In residential real estate, the gross rental yields are usually in the range of 3-5 percent per annum of the market value of the property while this figure jumps to around 6-10 percent in the case of a commercial property. “The overall returns estimated over 10 years, are now around eight to nine percent per annum in the residential realty sector, in comparison to 13-15 percent per annum in the commercial realty sector,”

What is Commercial Property

Commercial property is real estate that is used for commercial activities like offices of companies, large residential properties that are rented out, etc.. Properties that are capable of bringing in the highest return on investments are typically those with the highest number of tenants.These commercial real estate properties can include multifamily projects, student housing, office space, self storage facilities, and mixed use buildings.

What is the Difference Between Residential and Commercial Property

Barriers to Entry

Traditionally, commercial property has made it difficult for investors to obtain debt, and banks continue to lend at lower loan-to-value ratios than residential property. For investors, this entails putting more money into the project. Commercial LTV ratios range from 40 to 60 %, whereas banks lend up to 90 per cent on a residential asset. However, increased leverage entails increased risk for the borrower as well as higher interest costs. This high entry barrier has kept many investors out of the commercial real estate market. Even though companies like 100acress is giving all investors access to the once-inaccessible sector by lowering equity minimums on high-grade institutional, commercial property.

It could be argued that commercial property necessitates significantly more research before making an investment decision, which is another reason why investors are hesitant to enter the retail real estate market. Investors in both sectors must investigate the title, covenants, building reports, and market fundamentals. On the other hand, commercial property necessitates further investigation into seismic strength, underlying tenant covenants, operational efficiency, building services condition, outstanding warranties or consents, and so on.

Commercial leases are more likely to include specific terms under which the parent company will guarantee the lease if the tenant fails to meet its obligations. This is a valuable safeguard that is not commonly found in the home. Investing with a manager like 100acress allows investors to tap into the expertise of an in-house investment team, which conducts rigorous and thorough due diligence on every property brought to market, taking the headache out of commercial property investment.

Returns Profile

Rental income growth is the primary driver of long-term capital growth. Commercial tenants typically sign long-term leases, with leases of more than ten years not uncommon. This is usually built into the lease for commercial property, with fixed and market rent reviews. Specific lease terms may include a mechanism that prevents the rental from falling below the previous level.

It is unusual to find this structure in residential leases, which reduces income certainty for a residential investor. 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.

Supply and demand constraints drive both the commercial and residential sectors. However, because households pay residential rents, rents are linked to household incomes, and wage growth in OECD countries has been a dismal 6.3 per cent since 2008.

The bottom line for investors is that you can charge more rent per square metre for commercial space than residential space, resulting in a higher return on investment. On average, commercial property will typically yield 5% to 8% per year, depending on location and supply/demand for retail space, whereas residential properties usually yield 1% to 5% per year.

Risk Profile

In general, cash flows in commercial property are much more stable and secure than those in residential property due to the long-term nature of the leases. Residential tenants typically sign much shorter leases, usually six months or a year, with break clauses that allow them to leave the property with little notice. Compared to commercial property, this implies a higher risk profile of the underlying income stream for the investor.

In contrast to commercial property, the lease structure for Residential Property in Gurgaon typically requires the owner to be responsible for repairs and routine maintenance. It is common in commercial property for the tenant to be responsible for most property management, repairs, and regular maintenance; however, this varies depending on the lease.

Both sectors have historically been plagued by liquidity issues or the ability of an investor to withdraw funds from their investment quickly. The commercial industry has responded with listed property funds and REITs, which provide investors with indirect access to commercial property while also improving liquidity for participants.

Liquidity in direct commercial property, on the other hand, remains constrained within traditional property syndicators. The introduction of a secondary trading platform will significantly improve liquidity in the immediate commercial property space. 100acress is currently developing such a platform, which will allow investors to trade commercial property shares on a secondary platform.This procedure can take anywhere between 30 and 50 days to complete.

Valuation Method

The residential market can exhibit somewhat irrational valuations, driven more by owner-occupier sentiment than by investor sentiment. Comparable properties influence further evaluations in the area, which are frequently beyond the control of investors. This can lead to increased volatility, as the residential market is arguably more directly exposed to movements beyond one’s control, such as changes in interest rates. Interest rate movements have varying effects on different sectors of the commercial market and over varying timescales. Fundamentals, such as the current value of future income streams, drive commercial property valuations much more.

The basic difference between residential and commercial types of real estate is that in the first, people invest in properties like houses, apartments, villas, focusing on properties where they can live or rent out to tenants. In the latter, the investors focus on properties like shops, office spaces, warehouses, hotels, restaurants, etc.

The relationship between a landlord/owner and a tenant in a residential space is more private and close than in the case of commercial real estate since the people are not actually living in that space.

However, the rents are costlier in commercial property and the lease tenure is also longer, so while the investment in a commercial property is higher so is the return. While the return is higher in the case of a commercial property, so is the risk. Unlike residential property, the rental value of commercial properties can drastically decline when the market slows.

And while the rent is higher on commercial properties, factors like space, location can deeply affect its rental value.

Also, it is easier to find tenants for the residential property than a commercial property due to lower rent. The resale of a residential property is also more hassle-free than that of a commercial property.

Further, the onus of maintenance of the residential property falls on the owner while in the case of a commercial property, the tenant is responsible.

But acquiring a commercial property is more complicated than a residential property in terms of legal matters, registration, etc. Also, delayed possession can be a big disadvantage in the case of a residential property.

Now that we know the basic differences between the two types of real estate investment, let’s see how the rent would be.

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