Commercial v residential investments

Residential property can set a solid foundation to build on, but the fact is that residential property yields are far too low for many people to ever retire on. In my opinion, the fastest way to generate a workable passive income for retirement is through commercial property, which is why I personally made the switch to invest in this asset class, and since that day I have been hooked on commercial investing.

Let’s explore some of the reasons why residential property may not be the ideal investment class to adequately support you in retirement.

The traditional path to success in property investing

To generate a reliable income out of residential property, the most effective strategy is to have very low debt levels, together with a very large asset base. Even then, unexpected vacancies and maintenance issues can tear apart your cash flow returns – so it’s essential that you put a buffer in place to deal with these.

Many residential property experts will recommend buying multiple residential properties, holding them for a couple of decades and waiting for the rental income to grow, while reducing the debt at the same time.

The idea is that by the time two decades have passed, the mortgage should be fully paid off – with the help of your tenants – allowing you to enjoy the rental return as your income.

For me, this was just too slow a process. I was able to quit my day job at the age of 28 by employing a much more aggressive strategy, which involved leveraging commercial investments and taking advantage of their high yields.

The other key flaw in this long-term residential hold strategy is that, even when your residential property is debt-free, the yields are too low when compared to those of other asset classes, hence it’s an inefficient use of your capital.

There are lots of opportunities to buy a commercial property at a lower price point and with a good-quality tenant in place.

For example, if you owned three residential properties worth $700,000 each, and they were all completely paid off, you would have $2.1 million worth of property assets. Sounds great, right? However, at a 4 per cent gross yield, your income on your debt-free property would only be about $60,000 per annum after council rates and water bills, insurance and maintenance costs have been taken into consideration. You would also need to factor in income tax that would be payable on your $60k rental income.

For a portfolio worth $2.1m with no debt, $60,000 in gross pre-tax income just doesn’t cut it I’m afraid!

Let’s assume that instead you invested $2.1 million in commercial property offering a 7.5 per cent net return. With the tenant picking up many of the ongoing costs, such as council rates and maintenance, this investment would pay you $157,500 per annum after costs. Of course, income tax is still payable on these profits, but if you’re comparing commercial with residential returns over the long term, there’s a clear winner here. It’s a no-brainer, right?

These are big numbers I’m talking about here, but there are a lot of opportunities to buy a commercial property at a lower price point and with a good-quality tenant in place. People often think commercial is a highly expensive asset class that requires millions of dollars to get into, but the reality is that you can find a commercial property in a capital city for $350,000 – or sometimes even less.

With a good tenant in the property, a longer-term lease than residential, and cash flow that is much better than residential returns in the current market, investors are increasingly looking to commercial opportunities. A 7 per cent net yield on a property priced between $300,000 and $400,000 can deliver hundreds of dollars per week in positively geared cash flow.

Median capital city house prices: A matter of capital growth

There is a misconception that you don’t get capital growth out of commercial property, but this couldn’t be further from the truth. It’s all about supply and demand, with ratios and fundamentals that are just like those of residential investments.

Some of the fastest-growing deals I’ve ever done have been in commercial. I owned a property myself in the Newcastle area; it was a little warehouse, and in one year it grew in value by 26%.

It grew that quickly because, in summary, interest rates were dropping, and I was able to negotiate a slightly better rental return and lease, which meant the market was willing to pay more for the property than what I paid for it.

There are lots of opportunities to buy a commercial property at a lower price point and with a good-quality tenant in place.

During this same period, residential properties didn’t grow in value that quickly. One of the main reasons why people are more comfortable about investing in residential real estate, aside from the fact that it is familiar to them, is that they believe the capital growth prospects will be stronger, but this isn’t always the case.

Furthermore, do investors really understand how much growth they can expect over 30 years?

Let’s review price changes over 30 years in the table below.

As you can see, the average house price growth in our capital cities is between 5.2% and 6.42%. This level of growth is not too exciting, considering that the last 30 years represents a period that many would argue as being the greatest growth period for residential properties that we will ever see.

Don’t get me wrong: this is good capital growth. But when most investors rely on negative gearing to maintain their cash flow and make their investments affordable, the result won’t be sending you into early retirement, unless you try something different.

Let’s now look at how commercial property can swing the early retirement odds back in your favour.

Commercial property paydown strategy

Higher net yields: When it comes to commercial property, the returns can be significantly higher than those of residential.

In 2021, we at Rethink Investing are still finding quality, tenanted commercial properties in capital cities with yields of between 6.5 per cent and 8.5 per cent net.

These are extremely good yields considering most of my clients are getting commercial loans with interest rates that start with a 3.

Strong debt reduction strategy: One of the common strategies of my clients who invest in commercial properties is to use the high net incomes from the commercial properties’ rent to pay down the loans over time. This allows the commercial property owner to pay their debts down to zero in half the time of a standard 30-year loan contract – sometimes even sooner.

What many people do not realise is that high-yielding commercial property can pay itself off in 10 to 12 years. This is possible because the high cash flow from the net lease can be so strong, and if you can put the surplus rent back into your mortgage or offset account, the debt will rapidly reduce, without you having to make any extra payments.

Let’s have a look at the numbers in the example of a commercial property (see table above), which shows what happens when you deposit positive cash flow back into the debt.

This is an example of a property with a 7.5 per cent net yield and 3 per cent increases in its rent per annum. Without the owner having to inject any of their own funds, the property is completely paid off in 12 years.

However, more importantly, this property offers a $96,239 passive income with zero debt at Year 12. These types of returns can only be gained from commercial property, and for that reason this is an extremely important asset class for investors looking to speed up their journey towards an earlier retirement.

With risk comes reward

Part of my job is to educate investors on the benefits of putting their money into commercial assets, and reassure them about the risks involved.

As with residential property, finding the right commercial property is the key to success. However, there is much more due diligence required for those investing in commercial property compared with residential property.

In my opinion, most of the properties advertised on the internet do not stack up once you carry out the full scope of due diligence required. It takes time, dedication and an experienced operator to pick the right commercial investments. For instance, we look at and reject around 30 properties for every single one we purchase on behalf of a client.

When you find the right deal, commercial properties can exceed the best of what you can find in residential, which is what makes this a tough but exciting asset class to invest in. The numbers speak for themselves, which is why I chose this as my favourite path to go down as an investor.

If you’d like to invest in a commercial property, how do you go about minimising the risks? Just as you would with a residential property, you need to start by doing your research. You need to talk to a lot of experts in the field who have purchased these types of properties before, and get familiar with this asset class by calling up commercial real estate agents, even if it’s just to ask them about recent sales and the listings they have coming up.

There’s not as much data out there in terms of sales and trends when compared to residential investing, and there are not as many good books to read on the topic. That is why you need to talk to people who have been there and done that – preferably for many years and over multiple deals. You want to speak to investors who can tell you both the good side and the bad side of commercial property investing so you can build your knowledge and take your time.

Commercial property investing offers a number of benefits to the savvy investor, which is why my main piece of advice is simply this: be open to it. It’s still such a fresh, unknown, less-spoken-about asset class when compared to residential, but it’s a major part of the Australian economy. And the more we continue to have conversations about it, the more people will realise that there are high-quality deals to be had in every price range, in every city.

Disclaimer: The advice contained in this article is for general information only and should not be taken as financial advice. Please make sure to speak to a qualified professional person before making any investment decision.

Scott and Mina O’Neill are co-authors of Rethink Property Investing (Wiley $29.95) and founders of Rethink Investing, Australia’s number one buyer’s agency for commercial property investors. After retiring at the age of 28, they now live off the passive income generated by their personal $20 million property portfolio and have helped over 1,800 clients purchase around well over $1 billion in Australian real estate. Find out how to do the same at www.rethinkinvesting.com