Residential Investors Turning to Commercial Investment?

In recent years, an increasing number of residential property investors have begun exploring the commercial property market as a more lucrative and stable investment option.

Among these investors, many are so-called “mum and dad” investors who typically own anywhere from one to several residential properties. Their shift toward commercial investments stems from growing dissatisfaction with the performance of residential property.

“A common theme is that residential property investors are becoming frustrated with rising house prices, which, when coupled with conservative rental growth and stricter regulations, have significantly impacted overall returns,” says Lance Judson, Commercial General Manager at Property Brokers Real Estate.

“What was once a reliable avenue for wealth creation and retirement security is now under pressure, leaving investors searching for alternatives. Commercial property, by comparison, offers compelling benefits. Yields of 5–7% in many towns, coupled with fewer compliance obligations and longer lease terms, make it an attractive option. For investors who are tired of the constraints of residential property, commercial real estate presents an opportunity to diversify their portfolios and achieve stronger returns” Judson believes.

But what exactly are the differences between residential and commercial property investment?

Key Differences Between Residential and Commercial Property Investment

1. Bright-Line Test

• Residential: The bright-line test is essentially a capital gains tax applied to profits made on residential properties sold within a two-year period (or five years under previous rules). The tax, charged at the investor’s highest income tax rate, does not apply to properties deemed as the owner’s permanent residence. This test creates a significant deterrent for residential investors looking to flip properties quickly for a profit.
• Commercial: Commercial property investors are not subject to the bright-line test. This means they can freely buy, sell, and trade properties without worrying about capital gains tax, providing greater flexibility and reducing tax-related constraints.

2. Tax Deductibility

• Residential: Recent changes have reinstated the ability for residential property investors to deduct mortgage interest payments as a tax-deductible expense. However, this policy remains politically contentious and may be reversed in the future if there is a change in government. This creates uncertainty for residential investors, who could see their tax benefits fluctuate with political shifts.
• Commercial: Tax deductibility rules for commercial properties have remained consistent. Owners of commercial investments, such as retail spaces, offices, warehouses, and factories, have always been able to deduct mortgage interest payments as a legitimate expense, making it a more predictable and investor-friendly option.

3. Healthy Homes Standards

• Residential: Residential landlords must comply with strict Healthy Homes Standards, which include ensuring properties have ceiling and underfloor insulation, adequate heating to maintain a minimum indoor temperature of 18˚C, ventilation systems like range hoods and bathroom extractors, and more. These compliance requirements involve significant costs and ongoing maintenance obligations.
• Commercial: There are no Healthy Homes Standards for commercial properties. While landlords must follow local council regulations, the burden of meeting tenant-specific requirements (such as installing custom heating or ventilation systems) often falls on the tenant. This arrangement reduces the compliance costs for commercial landlords and shifts much of the responsibility to the tenant.

4. Loan-to-Value Ratios (LVR) and Debt-to-Income Ratios (DTI)

• Residential: Residential investors face increasing scrutiny from lenders, who require them to meet strict LVR, DTI, and Uncommitted Monthly Income (UMI) criteria. While a 20% deposit is standard, banks may consider a 10% deposit under special circumstances. These tight lending conditions can limit the purchasing power of residential investors.
• Commercial: Commercial lending operates under different rules, with a 40% deposit being the norm. However, lending terms are often more flexible, depending on the investor’s relationship with their bank and overall financial position. While the higher deposit may seem like a barrier, the potential for higher yields and fewer regulatory restrictions often offsets this requirement.

5. Returns and Yields

• Residential: Rising property prices, capped rental increases, and wage growth that lags far behind inflation have squeezed rental yields. Government regulations also limit the frequency and amount of rental increases, further reducing the profitability of residential properties.
• Commercial: Commercial properties offer a broader range of opportunities, with entry points starting as low as $50,000 and going up to $50 million or more. Depending on the property type and lease terms, returns can range from 5% to as high as 50%. Investors can negotiate lease agreements with rent reviews tied to market rates, CPI, or a combination of both, ensuring rental income keeps pace with inflation. Smart leases also include ratchet clauses, ensuring rents only increase over time.

6. Lease Terms

• Residential: Most residential tenancies are short-term agreements, either periodic or fixed-term. Tenants can leave with as little as 21 days’ notice, and landlords in the past have faced restrictions on terminating agreements without cause. This lack of certainty often results in higher tenant turnover and less stable income for landlords.
• Commercial: Commercial leases typically range from three to 25 years, offering long-term stability for landlords. Longer lease terms improve the Weighted Average Lease Term (WALT) of the property, which directly increases its value. Furthermore, there is no Tenancy Tribunal for commercial leases, meaning disputes are resolved through negotiation or legal avenues rather than government-mandated oversight.

7. Operating Expenses (OPEX)

• Residential: Landlords usually bear the full burden of operating expenses, including rates, insurance, maintenance, and water charges. These costs can significantly reduce the net return on investment.
• Commercial: In commercial property, tenants often pay not only the rent but also the OPEX, which includes rates, insurance, maintenance, and even property management fees. This arrangement allows landlords to reduce their expenses and maximize returns, making commercial investments more financially appealing.

“When you compare the two, it’s easy to see why residential investors are increasingly exploring commercial property” says Judson. “Commercial investments offer stable, long-term returns, fewer regulatory burdens, and opportunities to offload costs to tenants. In contrast, residential property investments are becoming more complex and less lucrative due to government regulations and market constraints. For those seeking diversification and better financial outcomes, commercial property is emerging as a logical and attractive choice in today’s investment landscape”.

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Property Brokers Commercial property division offer a full spectrum commercial real estate, business broking and exit strategy service. Our commercial salespeople come from extensive business backgrounds in many different industries, and they take pride in the expert knowledge they have of the local property markets.

For more information, please visit:pb.co.nz/commercial or contact us today.