Property development comes in a variety of different forms but falls under two main categories, namely residential and commercial. Although there are similarities between the two, there is a distinct difference in use by the two, which can be defined as:
- Residential property development revolves around building residential home units and selling (in some cases rented) to homebuyers, families and smaller investors.
- Commercial property development is focused on business, where they are developed to achieve a predetermined business objective. They are used as an investment to meet an anticipated rate of return on the funds invested.
Both are feasible development options, but which is more profitable? This will depend on several factors which we explore further in this article.
Why residential developments?
Why do most people develop residential buildings? Unless they are a government organisation, the obvious answer is money and success. History has proven that the astute developers have made significant profits from residential developments. Every developer will have their own financial goals, and this will be dependent on several variables such as income, age, taxation, social status and so forth, but the underlying principles remain the same, and that is success and wealth.
With almost every prosperous financial reward there is the element of risk, but with property development, these risks can be calculated and analysed. Everybody needs a home or some form of accommodation. Like a general commodity, there will always be a demand for housing. As long as there are economic stability and population growth, this demand will continuously increase. This gives the watchful entrepreneur an array of development opportunities.
Residential developments can be lucrative, but the returns will be relative to the scale of the project. Whether you are renovating a home or undertaking a retirement village complex, there are many financial rewards in residential property developments.
Why commercial property?
Some people may theorise that commercial property is a skill, but the art of commercial property is the understanding of how a property fits in a market and how its users and its reputation perceive it.
For entrepreneurs who possess the knowledge and skills, developing commercial real estate can offer an enriching business opportunity. However, developing a commercial property is a challenging business undertaking that requires not only a substantial financial investment but also a sound understanding of commercial tenants’ requirements, as well as planning laws and project management.
Residential versus Commercial
What are the differences between residential and commercial properties? Should you invest your time exclusively in only one type or have a mix of both in your development portfolio? Although the principles of developing are similar, you should be aware that these categories have their own merits and demerits. These variables determine the differences between residential and commercial real estate which are evaluated under the following headings:
- Most residential developments require a smaller amount of capital to get started. Depending on one’s financial position some lending institutions would not require a deposit, and at times only 10% to 25% deposit is required to start. With residential, lending institutions have the infrastructure and systems to make home loans more accessible for the consumer to apply for.
- Commercial developments require more significant capital; the application for funding is more complex and would take longer in obtaining approval. When banks evaluate a commercial loan, they generally will look at a loan of 60% or less.
- Depending on its location, residential developments can cater to a broader market. The market covers singles, married couples, families, retirees and smaller investors. In addition, it is easier to market a residential development as it can be broken down into smaller sections. For example, an apartment block can be divided into strata sections and sold to several purchasers at an affordable cost.
- With a commercial development building, there are two markets. Firstly, some tenants are mainly large businesses and small business owners as tenants. When selling the completed development, the market is relatively small, e.g. a small office block or shopping centre would look to a single purchaser. For larger projects, the buyers would be a more substantial corporate investors or super funds but would want the project fully tenanted.
Buy-in land prices
- Residential land for new development tends to be more available in both greenfield and brownfield locations. Depending on the demand in the property cycle at that time, land prices can generally be more competitive.
- Commercial development sites in the right location, such as a well-established inner-suburban area always in demand and developers will often pay a premium to acquire such properties. Buy-in-prices for commercial properties are substantial and are usually purchased by wealthier groups or corporations.
- Probably the most significant difference between commercial properties and residential properties is in assessing its value. With residential, the value will be based predominantly on supply and demand. The value of a residential property is calculated by comparing the market price of similar properties in that specific olocation. An licensed valuer is responsible for estimating the value of a house.
- In commercial properties, value is determined by the inverse proportion to the degree of risk inherent to the continuance and stability of the income stream from the property, this means that no matter how attractive the commercial building may look or how much it had cost to build, the bottom line in assessing its value will depend on the leases and the net income stream the building produces.
- When undertaking market research for residential development, the market is more localised meaning the study is generally conducted within the suburb and the adjacent suburbs. One would look at the price point of similar homes and the general demographic profile.
- With commercial property development, the research would be broader and reviewed on a macro or regional level. For example, a shopping centre development the study would take into account the spending power not only within the specific suburb of the development but several suburbs beyond.
Type of purchasers
- Residential purchasers entering this market are not as sophisticated, compared to seasoned investors found in commercial properties. An offer on a residential property is generally completed on a standard offer and acceptance executed by a real estate agent, whereas with more significant commercial properties a solicitor would be required to formalise the purchase.
- Being more sophisticated, commercial property buyers will generally negotiate actively on several issues, therefore, delaying the settlement that in turns affects the developer’s profit. The purchase contracts are similarly more complex.
Tenants and leases
- Tenants for residential property look for residences where location and local amenity are at the forefront in their minds. Even if the rent for a high-quality residential property is low, the investor will be compensated by good capital growth. A residential lease is less detailed and less complicated. These leases can be bought “off-the-shelf” as standard residential leases. The lease period for residential property is short ranging from a few months to three years and are therefore often be subject to periods of vacancy. The annual rental escalation is low and is dependent on the demand for a rental property in a specific location.
- Commercial property leases are often based on the precise requirements of business tenants and are generally longer from 3 to 10 years with escalation related to CPI (Consumer Price Index) with rent reviews within an agreed period. During tough economic times or with intense competition, developers will have difficulty in finding commercial tenants and will offer generous lease terms. This can be in the form of rent-free periods or significant expenditure to meet the tenant’s specific planning requirements. One of the key benefits of a commercial lease is that the tenant is responsible for all outgoings such as rates, land taxes, insurance etc. whereas with residential these costs are the responsibility of the landlord.
- Most residential tenants have a variety of properties to choose from and if they do not like your property or your rental they can just as quickly find another property, which creates competition between landlords. Most yields in residential properties range from 3% to 5%.
- With commercial properties, on the other hand, the rental yields are much higher ranging from 5% to 8% or even higher depending on the location and the supply and demand for the commercial space. Most business owners when they come to view a commercial property they would have done their homework and evaluated whether the location and traffic are suitable for their business.
- Housing prices fluctuate according to supply and demand. Quite often during a boom period, housing prices peak and sets the benchmark for future prices. The capital growth in this instance can be quite significant.
- Prices on commercial buildings, on the other hand, are governed by the leases they have in place and only increase in value relative to the escalation clause in the lease. This escalation in a lease is generally linked to the consumer price index (CPI), which has been relatively low past ten years. With longer commercial lease over five years, a rent review clause may be added so that the rent is adjusted to market value.
- Many investors or homeowners in residential property can enjoy the prospect of enhancing the value of their properties, through the construction of a second storey, a renovated kitchen or a new garage.
- A negative aspect of commercial property is the owner’s relative inability to enhance the value of the property through judicious renovation or extension. Moreover, most owners of commercial properties are reluctant to undertake expensive improvements that might turn out to be inappropriate for a future tenant. However, on the positive side the owner, by renovating the building could change the lease on more favourable terms thereby improving the returns and capital value of the building.
- Home rentals are determined by comparable market rates of similar houses in that area. Tenants pay their rents on a weekly or monthly basis depending on different countries. Although rental growth can vary according to location, commercial property offers more excellent opportunities for rental growth than those achieved by residential properties.
- Most commercial leases link rental growth to the Consumer Price Index (CPI), which is not always achievable with residential property. With commercial properties, it may be possible to negotiate a specified annual rate, above the CPI. Rent reviews are also quite common with commercial leases where the landlord may review the rent currently paid by the tenant. This review takes into account any economic growth and the state of the market in that specific sector and locality.
- Residential tenants are generally available regardless of the economic market conditions. The reason is that most people want to live and rent in places close to their friends, families, job location, educational institutions, etc.
- Commercial properties can be harder to lease due to the precise requirements of commercial tenants. Sometimes, owners who are pressed to find a commercial tenant will offer generous lease terms to make sure that the property is not vacant.
- Easier to finance
- Larger purchaser base
- More development land available
- Valuation based on supply and demand in a specific area
- Market research localised
- Less sophisticated purchaser – shorter negotiations
- Shorter lease periods
- Lower yields 3% to 5%
- Greater capital growth in boom times
- More opportunities for building improvements
- Shorter vacancy periods
- Complex funding
- Smaller purchaser base
- Land for development limited
- Valuation based on the net return of the property
- Market research at a macro or regional level
- Sophisticated purchasers – longer negotiations
- Longer lease periods
- Higher yields 5% to 8% or higher
- Limited capital growth according to CPI
- Less opportunities for building improvements
- Longer vacancy periods
Which is more profitable?
This will depend mainly on the developer’s financial position but more importantly on their experience and knowledge of the residential or commercial property and its market.
From a development perspective, most residential developers build and sell their product and have handsome profits when the residential market is booming. This, of course, means cash in hand to undertake another project but the tax would have to be into account as well. Whereas, with most commercial developments these are built to be held as a medium to long term investments. While there is no cash, the growth in one’s equity position can grow significantly if the development is successful.
If one has to compare the two categories as a build to rent and to exit in 5 years, it has been found through historical evidence that commercial developments are more profitable. From the earlier comparative assessment, that there are more risks involved in commercial properties. Remember, the higher the risk, the more profitable is the investment. However, one would have to be knowledgeable and experienced in the commercial sector.
There are undoubtedly several top-quality commercial developments within most capital city’s diverse suburbs. However residential properties offer developers far higher levels of control over the performance of their assets. Developers in high-grade residential property in established inner-suburban locations can anticipate stable tenancies and robust capital growth.