Most property investors start by investing directly in residential property. Perhaps first by purchasing a home and then adding a couple of rental properties. During the recent property boom we noticed younger, more aggressive investors delaying the purchase of their own home in favour of getting into the residential rental market earlier.

There are a number of good reasons for initially investing in the residential rental market. Firstly, residential rental properties are generally relatively low risk investments. No matter what the state of the economy people still need houses to live in. However, the more heavily geared or leveraged the investor is the more risk they take on.

Other good reasons to start investing in residential rental properties are that the market is easily understood, slow moving and predictable, and people feel comfortable owning tangible bricks and mortar. Maybe there is also a bit of the “number 8 wire” mentality – many NZers fancy themselves as “doer uppers”, home handymen, and landlords. Residential property investors generally feel a sense of personal control over their investments.

And banks will usually lend 80% of the purchase price of residential property. During a booming residential property market banks are often willing to fund most, or all, of the purchase price.

Commercial property on the other hand is generally less understood by novice investors.

The commercial property market is driven by completely different factors. While residential property market prices are driven mainly by supply and demand of homeowners and investors, the commercial market is generally driven by global, national and local economics.

When the economy is booming, most businesses do well. Businesses then employ more staff, invest in plant and equipment, and move to bigger or fancier premises. This puts upward pressure on commercial property prices.

On the other hand when the economy is in recession more businesses fail or downsize, and commercial property prices generally weaken.

It is a cliché that an average annual rental return (excluding capital gains) for commercial property is 10%, while it is usually significantly lower for residential property. Taking this cliché one step further, commercial property has historically been valued at roughly 10 times the annual rental - a property renting for say $100,000 pa would generally be worth $1m.

If the property was particularly desirable, perhaps because of a quality tenant with a very long term lease in a great locality, then the rental yield maybe lower (say 8%) which would value the property at $1.25m. However, if the property was not so desirable, (perhaps because of the tenant, or the building not being well built or having less general market appeal, or located in a less sought after area) then the average rental return may be higher, say 12%, which would value the property at $833,333.

Commercial property generally costs more than residential property. Investors with limited capital often start in the residential market for this reason. It is generally easier to afford several residential properties than a commercial property, improving diversification and reducing risk.

Banks will usually lend only 50%-70% of the purchase price or valuation of commercial property, depending on the state of the economy and investment markets. Investors must therefore invest more of their own capital in commercial property than residential property.

However, commercial property has a number of advantages over residential property, including: 

• Higher average rental yields
• Longer lease terms, which are generally easier to manage 
• Regular rent reviews, leases often have “ratchet” clauses built in so that rents can not go down 
• More stable tenants as it is costly for businesses to move premises (and they may also lose customers and goodwill by moving) 
• Commercial tenants pay most or all of the property outgoings including rates, insurance, building and lift maintenance etc 
• Commercial tenants often personally guarantee the rent, giving more security to the landlord 
• It is often easier to collect commercial rent arrears or evict a commercial tenant in breach of their lease than a residential tenant.

How can novice property investors get into commercial property if they don’t have a lot of capital? Generally by way of property syndicates or listed property vehicles.

Commercial property syndicates were very popular in the 1980’s and 1990’s and are likely to become more popular once again. A syndicate would typically invest in one or a number of commercial properties and each investor would invest in multiples of $5,000 to $100,000. For as little as $5,000 an investor achieved commercial property yields and was able to achieve diversification by investing in a number of syndicates.

However, listed property vehicles are another option for smaller investors. These are listed on the NZ stock exchange and invest in a large number of properties with professional management. They generally have good liquidity (you can sell at short notice), diversification, and you can invest relatively small sums. However, since they are listed on the share market they are affected by overall market sentiment to a greater degree.

Both commercial and residential property investments have performed well over the recent boom. Strategic investors know not to chase last year’s winners, will look for opportunities to invest against the trend, and will plan accordingly.