3 days ago
Commercial property versus residential: Scott O'Neill shares insights
Interviewing him on The Prosperity Project podcast made it seem as though investing in commercial property is an absolute no-brainer and it was tempting to conclude I should immediately sell out of residential to get in while the going's good.
But then, he co-owns a business that shows people how to invest in commercial property, so I wondered whether I should be taking it with a pinch more salt. I didn't think he was wrong or misleading me about commercial property's virtues, but I thought – surely it's not as simple as that?!
Capital gains
Commercial property is a good alternative to residential property, O'Neill said on the podcast, because 'the 30, 40 years of [residential] growth might not be as good over the next 20 or 30 years'.
ANZ chief economist Sharon Zollner agrees that 'there is no way we can repeat the real gains in house prices seen over the last 20-30 years. Who would be buying them? No one could afford them'.
However, does that necessarily mean commercial property would be any different?
It's a little more complex to answer that (or, after researching this, I'd argue – a lot more complex!)
'It can be like comparing apples and oranges – you can do it, but you might not necessarily be providing the right comparison,' the head of research and strategic consulting at JLL New Zealand, Chris Dibble, says.
Residential prices 'can be more sentiment-driven, versus commercial/industrial sectors being more income-focused' Dibble says, plus there are fewer commercial transactions to compare, there are different valuation methods, lease agreements, and the outlook can differ by sector.
Rental returns
But it's not just about capital gains. 'It's about growth and cashflow,' O'Neill told me on The Prosperity Project, and the yields are much better than residential.
'You know, 6 or 7% net sounds a lot better than 2% net.'
It certainly does – and JLL's data show net commercial yields in New Zealand can range from 5% to 8.38% – depending on the region and whether it's office, industrial or CBD retail. In residential, the median gross yield is 4.52%, according to Opes data, but that's gross – ie before you factor in costs like rates, insurance, maintenance and property managers (which are covered by the tenant in commercial leases) so the net yield for residential could easily be 2%.
However, Dibble says: 'The reason those returns are higher is about the risk and return – for example, as you can imagine, capital expenses like recladding or reroofing commercial premises tends to be a lot more expensive than for a residential property.'
Lending
Those higher returns in commercial can unlock more lending, O'Neill told me. 'If you've got equity and they [the bank] say no more lending for residential, you can actually still keep going in commercial, assuming the asset you're buying has enough income to cover its interest rate.'
Mortgage broker and founder of Squirrel, John Bolton (who is a commercial property investor himself), says that does make commercial property particularly appealing to some types of investors.
'Where it can be attractive is for older borrowers who may have large amounts on term deposit with the bank, so they have lots of equity and can generate a good return without having to factor in their income.'
However, Bolton says that lending approach can be both a blessing and a curse.
'They [the bank] expect the income on the property to be more than 1.3 times the debt servicing cost – but can go up to 1.8 times. It typically means you can't borrow more than 40-50% of the property's value, you need much more equity. With commercial loans, you also have an annual review. If the valuation has gone down, if you've got a vacant property, or a property with issues, the bank can ask you to pay back some of the lending.'
'I love commercial property,' Bolton says, 'but it definitely carries significantly more risk than residential. It's not somewhere to go if you're a highly geared investor.' A point on which he and O'Neill agree.
Interest rates
I asked Scott O'Neill whether commercial investors are subject to much higher interest rates than residential investors. He told me: 'It might be half a per cent higher than your normal residential rate.'
That differential varies, according to Bolton, but in some circumstances can be lower than residential rates.
'Commercial properties are risk-graded, so it does depend on the type of property. Bigger commercial loans can have rates that are better than residential loans, but smaller commercial investors tend to get 1-2% above residential rates.'
The episode with O'Neill is well worth a listen (I know, I would say that) but I'm now a little less gung-ho about commercial property being my next investment than I was immediately after talking to him. There's a lot to consider, and while O'Neill's suggestion that commercial property is a lot less politically exposed is an excellent point, I think I'll remain a vilified residential property investor, for now.
Listen to the full episode of The Prosperity Project for more.
The podcast is hosted by Nadine Higgins, an experienced broadcaster and a financial adviser at Enable Me.
You can follow the podcast at iHeartRadio, Apple Podcasts, Spotify or wherever you get your podcasts. New episodes are released every Monday.
