If you were to believe the hype merchants, you’d think that residential property investment was a losing game. The market downturn is broadcast from every news app, legislative changes – removal of interest deductibility, the expense of healthy homes adherence et al – and low yields, leading investors to turn their eyes to “greener” pastures.

One of these pastures is commercial property. Investing in a commercial syndicate is less hands on: no need to worry about the RTA, Healthy Homes, or tenants who terrorise the neighbours. And it has a lower entry point, due to syndicates that can be accessed from as low as $10,000.

Commercial versus residential is an interesting topic. And the comparative figures are enlightening.

Total return figures from the residential market show it has outpaced the office, industrial and retail markets in rolling annual percentage terms every year for the past 15 years up until the end of March this year.

Total returns include capital value growth and rental returns.

Colliers International’s data for the table (see below) sourced from its own research, MSCI, a global commercial property investment research company, MBIE, and REINZ shows total residential returns in 2007 equalled 15.5 per cent compared with 11.7 per cent for commercial property. Three years later total residential returns were way ahead and peaked at 19.6 per cent, a huge 8.8 per cent ahead of commercial property at 10.8 per cent.

At the 10-year mark total returns for residential property were running 2.5 per cent ahead of commercial property and by year 15 ending in March this year, the rolling percentage of total returns for residential property had come back to 10.9 per cent compared with 9.2 per cent for commercial.

CoreLogic’s chief property economist, Kelvin Davidson, says residential and commercial property have always provided good long-term total returns when compared to other asset classes.

“The results show investing in property long-term pays off. Property prices don’t move in cycles by magic, there have to be good underlying fundamentals to them. Yes, residential property has done well over the past 15 years, but it might not over the next two to three years as house prices sink.

“Generally, when comparing commercial vs residential real estate capital gains are higher with residential property. In the past three years, there has been spectacular capital growth in residential property across the country. In fact, this trend has been reflected in many major capital cities and regions throughout the world.”

Residential property demand usually increases with population growth. On the other hand, commercial investment property prices are often a reflection of the existing business environment and the structure of any lease.

Although capital gains for commercial property are usually lower, some commercial properties can achieve spectacular capital gains because of local population increases, change of use, redevelopment or zoning changes.

So which is the best choice, commercial or residential? And what are the next few years likely to bring investors from each sector?

Returns Forecast

Davidson says it wouldn’t surprise him if total residential returns drop below those of commercial property for a short while, so investors need to be a bit more prepared than in the past by concentrating on rental yields rather than capital gains.

“In the past 18 months residential investors have been sent a clear message that the days of massive capital gains are over.”

Colliers International research associate director Ian Little predicts the figures by the end of March next year could be quite different. “Clearly, capital appreciation is linked to economic cycles and in the residential sector, in particular, changing tax policies, rising interest rates and inflation have had a big impact on house prices since the beginning of the year.”

More than $40 billion was wiped off the housing market in the first six months this year, with the total value of the sector falling to $1.69 trillion, down from $1.73 trillion at the end of last year, with mortgages secured against 20 per cent of that value, CoreLogic’s latest Property Market and Economic Update shows.

Davidson says this weaker phase for the property market will continue into next year, and even when the floor is reached, the experience of the 2008-2009 global financial crisis (GFC) was that it took another two to three years for the next upswing to start as values plateau, so it is quite likely total residential returns will drop.

“It’s possible the national average property value will ultimately drop by 10 to 15 per cent by the middle of next year, which broadly suggests we’re potentially halfway through this correction in both duration and scale.”

The returns for commercial property follow economic cycles, says Little.

In the past two years industrial has been the strongest performer with huge demand for logistics and warehouse buildings boosting returns. “The pandemic pushed the world to internet shopping and a huge amount of storage is needed for goods. Industrial returns have ridden the wave of a demand surge from investors for this type of stock.”

Little says the office sector has also fared well, despite offices being forced to work from home during the same period and hybrid work becoming the norm. Figures show there hasn’t been an enormous amount of volatility in office sector returns, although a recent JLL survey found three major Auckland CBD office buildings between 59 per cent and 22 per cent empty, while billions of dollars’ worth of new buildings are rising.

In the retail sector there has been big demand for supermarkets and bulk retail property while second grade retail outlets have suffered to a great extent.

Little says investors are always looking for opportunities in the commercial sector as they can’t get the returns from banks and this keeps returns ticking over. “There has been a lot of competition for commercial assets, particularly during the past three years.”

However, there are significantly more investors in the residential rather than commercial sector. “There is greater familiarity with residential as everybody needs somewhere to live,” says Little. “It’s the familiarity more than the ease of purchase, which motivates people to invest in that sector.”

Commercial Proves Attractive

Commercial has proved attractive for residential investors leaving that sector as the returns don’t fluctuate as much. Access is also easier through syndication and managed funds for those who don’t want to take the risk of buying an entire property themselves.

“Over the past 15 years the difference between the highs and lows has not been as great as residential,” says Little. “This reflects the longer, structured leases that show commercial landlords exactly what rent is going to be paid over the term combined with regular rent rises.”

Residential rental yields in recent years have dropped to about 2.5 per cent, but on the flip side capital gains have been much higher than commercial property.

Low interest rates, relaxed credit conditions and liberalisation of the financial sector compared to the past 20-30 years have allowed people to access money far more easily, contributing to rising prices and capital gains, bolstering returns.

Now the tide has turned with government and Reserve Bank intervention aimed at quashing investment in existing housing stock and moving investment to new housing.

Davidson says the government thought it could capture more sales to extract tax on if it increased the bright-line test to 10 years, but all investors will do is hold their property for a decade unless they have an urgent reason to sell. “The government probably sees this policy as a win, even though it is not going to capture much tax, but anybody who bought in the past three years is sitting on a very big bright-line tax bill.”

Although there has been a slump in mortgaged investor buying since the days they had a 30 per cent market share of the overall buying market, Davidson says they are still active at a 23 per cent share of the market.

‘Industrial returns have ridden the wave of a demand surge from investors for this type of stock’ Ian Little

And they are likely to stay the course.

“Instead of banking on big short-term gains, investors now see homes as assets they can pay off using rental income, gaining equity as the loan is paid down,” he says.

“Landlords in for the long run just want their mortgage paid off. If they have a good tenant they will, in most cases, keep on renting the property at below market rates to them and take any capital gain as compensation.”

He says there is still long-term appeal for buying residential property. “It’s still a good retirement plan.”

The focus is changing from competing to buy existing homes to buying new builds as these are exempt from the tax deductibility changes and many may end up in the rental pool.

Careful Sums

New investors will need to do their sums carefully and now might be a good time to buy, says Davidson.

“New investors might be able to bag a bargain now and be happy enough to top up the rent at the start and get a capital gain over time. Taking this approach can make the figures stack up.”

He says as a young pent-up population leaves New Zealand in droves after three years in a series of pandemic lockdowns, it will reduce the net demand for property unless more people arrive now the borders are open. A potential oversupply of residential property is another reason Davidson expects the next set of total return figures to show better rental yields.

Buyers now hold the balance of power, with plenty of stock to choose from and a cautious approach to how much they are prepared to pay for a property.