FINALLY ANSWERED Where are returns better – COMMERCIAL or RESIDENTIAL?

Commercial Real Estate returns reach up to as high as 8-9% as compared to the residential real estate returns which hover around 1-2%.

So isn’t it an easy decision to buy a commercial property. But if it would be that easy, we would see flow of capital in commercial real estate & the returns would eventually come down because of normal demand-supply mathematics.

But we still find it is quite a common dilemma that faces people with investible surplus – to invest in a residential property or a in a commercial property?

This dilemma stems from perceptions build across the years over each type of property. These perceptions which we call myths are in a dire need of debunking.

A Common Myth Debunked

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One of the most common & popular myths that is associated with the Residential and Commercial Real estate is the one we mentioned in the start itself – that the rate of returns on commercial real estate are higher.

To debunk this myth, let us try to understand the differences between the 2 types of properties. Residential and commercial structures are different from multiple points of view. They should not be measured with the same yard stick. I will tell you the reasons why.

1. Master Planning

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A commercial establishment is bound to have a heavy inflow of transit population. Many people will come & use the facilities there – shops, offices, theatres, restaurants etc. Given these factors, it is imperative that the town planners while planning ensure that the commercial establishment is better accessed using the arterial roads, and is a location convenient for the people residing around that commercial establishment. Clearly, the proximity to the main roads, the better location would mean that the land where commercial establishment is proposed to be setup will be expensive per unit area from the start itself.

2. Conversion Charges

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The commercial property needs to be provided with more resources than a residential property would need. Naturally, the government will charge more as conversion charges to get it developed for use.

3. Development of Property

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The cost structure of a commercial property will be higher at the time of development as well. Commercial structures have additional needs to create common areas to cater to the needs of the users. The needs of such spaces for escalators, lifts, restrooms on each floor, cafeterias and stopping regions is far less in normal residential structures. This adds on to the cost of the commercial area being bought as the loading factor is high in the carpet area one is buying.

4. Proposed Usage

Buying a property is a long-term decision. While buying, one also contemplates the usage of the property being bought – whether it will be for self-use or for giving out on rent etc. If we take the rentals part out, the usage is divided into 2 options – for staying purpose or income generating purpose. When it comes to income generation purpose, many factors go into the equation – what type of catchment will the location service, what has been the experience of other such commercial areas in the vicinity, what type of good or services can be sold, whether it will be able to sustain income generation for years to come, among so many others.When such analysis goes in, the options to choose from keep on getting limited. When the supply side gets limited, it is but obvious the buyer will have to pay more price for this exact match he wanted.

5. Financing Options

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When it comes to seek loan options for commercial real estate, the rate the Banks charge is higher than compared to the residential real estate. They fund only till 55-60% of the value of the property. They also give a lower tenure loan to the commercial real estate borrower. The Banks too wish to carry low risk on commercial real estate lending. They charge a little extra on interest by adding the risk premium of lending in commercial real estate. They want to lend for lower tenure – 10 to 12 years compared to 20 -30 years for residential real estate.

The Banks too are cautious when it comes to commercial real estate. They know it is for income generation purpose so they know the borrower could be in problem if income generation ceases to exist. Maybe better or more number of commercial complexes come in the vicinity, or the commercial property goes out of favor in minds of shoppers, or in general the footfall decreases. Hence the Banks also lend less money on the value of the property.

An investor in residential real estate can invest 20% of his own money and can actually calculate his returns on that 20% invested from his side. A commercial property investor will have to do the same calculation by investing 40% from his own side.

Learnings

It can be clearly seen that the investments in the 2 types of properties is not comparable.What can also be seen is that commercial real estate has a higher cost structure and thus it needs to be rewarded more for the kind of risks associated to it & the kind of treatment given to it by buyers, bankers etc. The development & maintenance of a commercial property is higher than that of a residential property. Also, everything depends on buying correctly. Any type of property, residential or commercial, if bought at higher prices will not give the returns we expect.

To simply put it, if we are doing the buying process correctly and are able to spot future winners in both residential as well as commercial properties, our decision to go for commercial or residential property ideally should depend on whether we are investing our own money or taking loan.

If we are investing our own money, we should go in for commercial property. However, if we are able to take more loan then we may look for residential property as well, that totally depends on our liquidity position and the outlook we have for the property to grow up.

What is more important is that one buys right price, right specifications with right financing options to emerge a winner in the transaction.