If you think investing in commercial property is the same as investing in residential property, think again. In reality, there are a number of material differences between these two types of property investment. You need to be aware of these before you buy.
1. Value
As simple as this may seem, you can only claim a tax deduction on an expense that you have actually incurred.
For example, if you spend time doing some repair work on your investment property, you cannot generally claim the time and energy you expended to do that work, because you have not incurred an expense, which generally requires you to pay someone something. In contrast, the cost of the materials used for repair work that are purchased at a hardware store will be tax-deductible. Likewise, if the repair work is done by someone else, then the cost of hiring that person will be tax-deductible for you.
2. Lease term
The lease term of a commercial property is generally longer than that of a residential property. For instance, it is not uncommon for a commercial property to have an initial lease term of five years, followed by an option granted to the lessee to renew the lease for another two lots of five years, ie the maximum term of the lease could span 15 years.
In contrast, most residential leases only cover six to 12 months, and are subject to negotiations for renewal after that period.
3. Rent
Due to the substantially longer lease terms of commercial properties, rent increases are usually codified into the lease based on a predetermined and agreed formula, eg the rent amount is increased at the same rate as the Consumer Price Index each year. This differs from the rent on residential leases, which is renegotiated and renewed every time the lease expires.
Further, the income yield on commercial properties is generally higher than that of residential properties. Commercial properties, which include industrial properties, retail premises and commercial offices, may provide a gross income yield of 6–12%, while the gross yield on residential properties is generally around 3–6%. Naturally, there may be exceptions to these general indicatives, depending on the unique features
and location of the specific property concerned.
This difference in the income yields of commercial and residential properties reflects the risk associated with these properties as investments. As the demand for commercial properties is generally more sensitive to prevailing economic conditions and subject to a higher level of market volatility than the demand for residential properties (ie people have to live somewhere irrespective of how the economy is faring), the higher risk of potentially longer periods of vacancy associated with commercial properties means they will generally provide a better income yield.
4. Outgoings
Unlike landlords of residential properties, landlords of commercial properties can generally pass on rental outgoings such as council rates, water rates, land tax, etc, to lessees as part of the rent, while landlords of residential premises are usually responsible for these costs.
Together with the generally higher income yield from commercial properties, the ability to collect outgoings may prove to be an attractive investment proposition for property investors who are willing to take on some extra risk.
5. Financing
Commercial properties usually have a higher value than residential properties of a similar size and in a similar location, which means the stamp duty payable on the purchase of commercial properties is also higher.
In addition, due to the higher risk profile of commercial properties, lenders do not generally lend as much relative to the value of the property as they do for residential properties.
For this reason, if you are interested in investing in a commercial property, you will need more equity to fund the purchase.
Lenders are generally prepared to lend up to around 65–70% of the value of commercial properties, but will lend up to 80% of the value of residential properties without mortgage insurance, and up to as high as 95% when the borrower is prepared to pay mortgage insurance.
Also, due to the higher risk associated with commercial properties compared to residential properties, the lending criteria are usually stricter and the cost of the loan (ie establishment costs and interest rate) is usually higher.
Despite the fact that the lease term of a commercial property is generally longer than that of a residential property, lenders are usually prepared to provide a much longer loan term for residential properties (up to 30 years) than for commercial properties (usually up to, say, 15 years).
6. Taxation
While the income tax treatment of commercial and residential properties is generally the same, except for some minor differences that are attributable to specific features associated with each type of property, the GST treatment is very different.
In the case of commercial properties, provided that the landlord is registered for GST or required to be registered for GST, the landlord will be making
‘taxable supplies’ when they lease their property, for GST purposes, and will therefore be liable to pay GST on the rent. The landlord will also be entitled to claim back the GST on the costs incurred in renting out the commercial property or properties.
In contrast, renting out residential premises constitutes ‘input-taxed supplies’, irrespective of the GST registration status of the landlord, which means the landlord will
not be liable for GST on the rent, regardless of whether they are registered for GST or required to be registered for GST.
However, the landlord will not be entitled to claim back the GST on the costs incurred in renting out the residential property or properties.
Conclusion
As explained above, there are a number of key differences between commercial property and residential property investments. Understanding these differences is essential in deciding which of these investments better suits your individual circumstances and investment needs.
