Commercial vs Residential Property: What Changes for Investors

Commercial vs residential property investment comes down to who your tenant is and what the lease says. Commercial tenants are businesses, leases are usually longer, and the tenant often pays many of the running costs, but vacancies can take longer to fill. GST, depreciation, finance and management also work differently, so the two are not the same investment with a different sign out the front.

Key takeaways

• Commercial leases are negotiated business contracts, while residential tenancies follow each state’s residential tenancies laws.
• Under a net lease the tenant pays most outgoings; with residential property the landlord usually pays rates, insurance and maintenance.
• Residential rent is input taxed for GST. A GST registered commercial landlord charges GST on rent and can usually claim GST credits on costs.
• The rule limiting deductions for second hand depreciating assets in residential rentals does not apply to property that is not used for residential accommodation.
• Lenders usually assess commercial loans differently from home loans, so speak to a broker early.

What is the main difference between commercial and residential property?

A residential property is home to a household. A commercial property is a place where a business operates, such as a warehouse, a shop or a medical centre. That one difference flows through almost everything else.

With residential property, value is driven mostly by what similar homes sell for, and the pool of possible tenants is large. With commercial property, value is driven mostly by the income from the lease and how secure it is. The pool of tenants depends on the property type and location, and some buildings suit only a narrow range of businesses.

Neither type is better for everyone. They suit different goals, budgets and levels of involvement. Many investors hold both at different stages.

How are commercial leases different from residential leases?

Residential tenancies are governed by residential tenancies laws in each state and territory. Those laws set many of the terms, such as bond limits, notice periods and how rent increases work.

Commercial leases are mostly negotiated between landlord and tenant. Terms of several years are common, often with options for the tenant to renew. An option is a right for the tenant to take a further term on the same terms. Retail leases are an exception in part, because each state has retail leases laws that add rules for many shop leases. Our article on commercial lease types covers those state rules in more detail.

Points that usually sit in a commercial lease and rarely in a residential one:

• Permitted use. What business the tenant may run in the premises.
• Rent reviews. Set dates and methods for changing the rent, such as a fixed increase, CPI or a market review.
• Outgoings. Which running costs the tenant pays on top of rent.
• Fitout and make good. Who pays for the fitout, and how the tenant must return the premises at the end. Make good means restoring the premises to an agreed condition.
• Security. Often a bank guarantee, which is a promise from the tenant’s bank to pay the landlord up to a set amount if the tenant defaults.

Who pays the outgoings on commercial and residential property?

Outgoings are the costs of owning and running a property, such as council rates, water rates, building insurance, repairs, cleaning of common areas and, in some cases, land tax.

With residential property, the landlord usually pays most of these and claims them as deductions where allowed. The tenant pays rent and usually their own utilities.

With commercial property, the lease decides. The common structures are:

• Net lease. The tenant pays rent plus most or all outgoings.
• Gross lease. The tenant pays one rent figure and the landlord pays the outgoings from it.
• Semi gross lease. The tenant pays some outgoings and the landlord pays the rest.

Retail leases laws in several states limit which outgoings a landlord may recover from a retail tenant, and some costs cannot be passed on at all. Always check the lease against the law in the state where the property sits.

Is vacancy risk higher with commercial property?

Vacancy works differently. A residential property can often be re let to a new household fairly quickly, because almost any household can live in almost any home.

A commercial property may need a tenant from a particular type of business, and that tenant may need to plan and pay for a fitout before moving in. A vacancy can therefore last longer, and you may need to offer incentives such as a rent free period to attract a new tenant. While the property is vacant, you also pay the outgoings yourself.

On the other side, a commercial lease often runs for several years, and a business that has spent money on its fitout has a reason to stay. That is why lease length, tenant quality and how easy the property would be to re lease matter so much. Our explainer on vacancy rates covers how to read vacancy data in general.

What types of tenants do commercial properties have?

Commercial tenants range from sole traders to large national businesses. The asset types we see most often are:

• Industrial and warehouses. Manufacturers, trade businesses, storage and logistics operators.
• Retail and shopfronts. Cafes, service businesses and shops, many on retail leases.
• Medical and childcare. Clinics, allied health practices and early learning centres. These tenants work in regulated industries, so licences and approvals form part of the checks.

When you assess a tenant, look at how long the business has operated, whether a director or parent company has given a guarantee, and whether the business could easily move elsewhere.

How do yields compare, and how do you work them out?

We do not quote market yields here, because figures change and depend on the property. What you can do is work out the yield on any property yourself.

Gross yield is the yearly rent divided by the price. Net yield uses rent after the outgoings the landlord pays. In commercial property, net yield is often called the cap rate, short for capitalisation rate.

Hypothetical example. A property bought for $1,000,000 with $60,000 net rent a year has a net yield of 6%. If the same property were on a gross lease with $70,000 rent and the landlord paid $10,000 of outgoings, the net yield would still be 6%. Comparing net figures avoids being misled by different lease structures.

Try the numbers on our rental yield calculator, and remember that yield alone does not tell you how secure the income is.

How does finance differ for commercial property?

Lenders usually assess commercial loans differently from home loans. They tend to look closely at the lease, the tenant, the property type and your own position, and the terms on offer can differ from residential lending.

Speak to a broker who works with commercial lending before you start looking, so your brief matches what you can actually fund. This is general information, not a recommendation of any lender or product.

How does GST work for commercial vs residential property?

The ATO says residential rent is input taxed. That means you do not charge GST on residential rent, and you cannot claim GST credits for costs of leasing the property.

For commercial property, a landlord who is registered or required to be registered for GST is liable for GST on the rent, and can claim credits for costs such as the GST in managing agent fees. A GST registered tenant may be able to claim the GST included in the rent.

The purchase can also carry GST, although a leased property sold with its tenants can be GST free as a going concern if the ATO conditions are met. Ask your accountant how GST applies to you before you buy.

How does depreciation differ for commercial property?

There are two kinds of tax deductions for the decline in value of a building and its contents.

Capital works. The ATO lets owners deduct the cost of building construction and structural improvements over time, at 2.5% or 4% a year depending on when construction started, the type of works and how they are used. Shop fitouts and other leasehold improvements can also qualify. The land itself cannot be written off.

Depreciating assets. These are items such as air conditioning units or carpets. For residential rentals, the ATO says that in most cases you cannot claim a deduction for second hand depreciating assets after 1 July 2017. That limit does not apply where the property is not used to provide residential accommodation, and the ATO gives a doctor’s surgery as an example.

A quantity surveyor can prepare a depreciation schedule, and your accountant can tell you what you can claim.

How much management does commercial property need?

Day to day, a well leased commercial property can need less contact than a residential one. The tenant often handles minor maintenance and may pay most outgoings directly or through the landlord.

The work that remains is more technical. Someone needs to run rent reviews on time, prepare outgoings budgets and yearly reconciliations, track option dates, manage essential safety measures and handle lease renewals or a new leasing campaign. Many owners use a commercial property manager for this.

If you are weighing up whether to get help with the purchase itself, our guide on whether a buyers agent is worth it sets out the costs and what you get. We buy industrial, retail and medical or childcare property for investors, as well as residential property.

Frequently asked questions

Is commercial property better than residential property?

Neither is better for everyone. Commercial property often has longer leases and tenants who pay outgoings, while residential property has a larger pool of tenants. The right choice depends on your goals, budget and how much risk you can carry.

Who pays outgoings on a commercial property?

The lease decides. Under a net lease the tenant pays most outgoings, under a gross lease the landlord pays them from the rent, and a semi gross lease splits them. Retail leases laws can limit what a landlord may recover.

Do you charge GST on commercial rent?

If you are registered or required to be registered for GST, you are liable for GST on commercial rent. Residential rent is input taxed, so no GST is charged on it.

Can you claim depreciation on second hand assets in a commercial property?

The limit on second hand depreciating assets applies to residential rentals. The ATO says it does not apply where the property is not used to provide residential accommodation. Ask your accountant what you can claim.

What is a cap rate?

A cap rate is the net yearly income from a property divided by its value or price. A property bought for $1,000,000 with $60,000 net rent has a cap rate of 6%.

Sources

• ATO: GST and residential property
• ATO: GST and commercial property
• ATO: Capital works deductions
• ATO: Second hand depreciating assets

Citadel Agency is a licensed buyers agency that also buys commercial property for investors.

Weighing up your first commercial purchase? Book a free strategy call with our team.

General information only. It does not take into account your objectives, financial situation or needs. Speak to a qualified professional before acting.

General information only. It does not take your objectives, financial situation or needs into account and is not financial, tax, credit or legal advice.