What are the differences between commercial vs residential real estate?
Commercial real estate is made up of properties that are for non-residential use. Prime examples of commercial real estate include office, retail or industrial real estate.
Investing in commercial real estate can be so complex and there are even nuances within the sub sectors in the sector. For those that own rental properties this guide aims to take residential real estate as the starting point of reference to highlight the key differences between investing in commercial vs residential real estate.
One characteristic of commercial real estate investments is that they are known to be more income driven. In some instances residential rental properties trade at a much tighter yield than commercial assets which result in a majority of investment returns come in form of capital gains.
Unless the investment is highly geared through the use of mezz loan real estate facility. Commercial properties are positive gearing assets in 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.
Commercial vs Residential Lease Agreements
Residential rental property leases are in most instances simple and almost standardized 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 respectively.
Commercial vs Residential Lease Types – Net vs Gross Leases
Residential leases are usually gross leases where the tenant’s obligation is just to rent due. The landlord is responsible for all of the building management and operating costs.
While there are some commercial leases like this there are in some instances where the commercial leases are called net leases. This means the tenant will pay the rent and outgoings which is made up of the operating costs of the building such as cleaning, repairs & maintenance, management and property taxes.
Commercial vs Residential Lease Terms
The terms of residential leases are typically for a period of 12 months while 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.
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 include annual fixed reviews which is agreed upfront between the landlord and tenant. This is a step up in the rent payments at fixed % such as 1-3% 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% 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.
Commercial vs residential real estate financing
Not all real estate is created equal and this is certainly true between financing commercial and residential rental 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.
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 capital structure possibilities 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 of commercial real estate. 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 for rental 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 the lower rate reflect the lower risk of the additional collateral. Also securing a lease can be critical in landing a competitive loan rate. Costs and difficulty in finding finance increase considerably if the space is vacant or the business plan is speculative.
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 (supported by Fannie and Freddie). Loans for commercial property are more conservative where the limit for the LVR usually tapers out after 60% although higher leverage is typically available for investors with higher risk tolerance.
Payment structures: It is standard for interest on commercial loans to be structured as interest only and a bullet principal on loan maturity.
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 CMBS or non-bank lender facilities. 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 or for industrial 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.