Shares vs commercial property: Which is the better investment?
Both shares and commercial property can give you huge returns and grow your wealth – but both have their risks. Here's how to decide which suits you best.
For investors, one of the biggest challenges is getting investment-grade yields or returns, which will generate an income that can actually sustain you long into retirement.
In this low mortgage interest rate environment, cash-flow returns have dropped across the board. This is particularly true for those who own a residential investment, where the rental returns are now much lower than they have been in the past.
Right now, yields are at record low levels due to the recent surge in capital growth. Rents haven't caught up or grown at the same rate.
Similarly, the only thing predictable about the stock market is that it will continue to be volatile.
Enter commercial property, where the yields are still at very high levels – to the point where any sophisticated investor will get excited. Let's find out more about this rising asset class, and compare it to the benefits of investing in shares.
Cheat sheet to shares
Australia has one of the world's highest share ownership rates, with around 35% of adults owning shares outside of their superannuation (source: ASX).
Owning shares involves purchasing a small portion of a corporation, which allows you to share the returns and preserved value of the business. Shares have generated reliable income and returns for Australians over the long run. And like residential property, the yields have consistently dropped in recent times.
The current yields for the S&P/ASX 200 Index are 2.7% p.a. plus franking credits (which is a type of tax credit paid by corporations to their shareholders).
When it comes to shares and equities, you can get started with as little as $500, sometimes less.
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As we all know, it's not easy coming up with the deposit needed to secure a property. So this barrier to entry is one of the reasons why people get into shares rather than investing in commercial property or even residential property for that matter.
Why are shares popular?
Shares are popular as they allow investors to have almost instant diversity. You can easily spread your money across a range of investments. Meanwhile, property investors typically invest in a very small number of assets.
Shares can be an exciting investment when you purchase well and see the day-to-day growth (or falls) in price. I have had good fortunes with shares and some very poor ones, just 24 hours apart.
This volatility is mostly driven by one thing – liquidity.
Liquidity refers to the ease at which an asset or security can be converted into cash. Property is not considered liquid because the process of selling can take weeks, if not months. Shares are considered liquid because you can easily and quickly buy and sell them.
Because people can sell out of the shares with a click of a button, this leads the share market to be an unpredictable beast. Even the world's best stockbrokers can have very little clue about what the prices of specific equities will be in 3 months' time.
Pros
- Low transaction costs
- Involves very little ongoing effort after an initial investment
- Easy to diversify
- Easy to buy and sell
Cons
- Easy to buy and sell
- Not a physical asset
- More volatile
- Lower yields
- Lower ability to leverage
Cheat sheet to commercial real estate
Commercial real estate is any type of property used for commercial purposes, such as a warehouse, retail store, factory, office or restaurant.
It's common to find commercial properties that generate yields of 5.5-8%. These are cash-flow net returns, which means they are the return you make after all expenses have been accounted for.
At Rethink Investing, we have been averaging 6.25% net returns in capital cities in 2021. What makes this yield even more special is our investors have been able to leverage up to 80% of the property's value, meaning they've only needed to put in a 20% deposit. With commercial property investments, the deposits required can be much higher, so these numbers represent really good value.
Why is commercial property becoming popular?
The yields when investing in commercial property are much higher than residential returns due to the tenants paying all your outgoings.
There is also less competition vs residential investing, and commercial property traditionally offers better cash flow, as more of your profits come from cash flow vs capital growth.
The difficulty investors face with commercial property compared with residential property is the fact that it can be harder for the everyday person to understand. Generally, you need to spend over $1 million to get a quality asset, and the risks can be greater if you make a mistake, like purchasing a poor quality commercial investment or purchase in a declining industry.
In summary, the cash flow returns are much higher – but so are the risks for the uninitiated. Let's look at the pros and cons of the commercial property asset class.
Pros
- Much higher passive income
- Tax advantages through negative gearing
- Ability to leverage up to 80% (though most stick to 70% or less)
- Better quality tenants on longer leases
- Ability to add value to the property or leases for equity gains
Cons
- More due diligence is needed vs buying stocks
- Expensive and illiquid asset class
- High transaction costs
If you are looking to build a passive income as your prime objective, the cash-flow returns from commercial property can be superior to share dividends and residential rental yields. However, diversification across different asset classes is key. A healthy investment portfolio should contain an element of both shares and both types of property.
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Scott and Mina O'Neill are co-authors of Rethink Property Investing (Wiley $29.95) and founders of Rethink Investing, Australia's number one buyers' agency for commercial property investors. After retiring at the age of 28, they now live off the passive income generated by their personal $20 million property portfolio and have helped over 2,300 clients purchase around well over $1.3 billion in Australian real estate. Find out how to do the same at www.rethinkinvesting.com
Disclaimer: The views and opinions expressed in this article (which may be subject to change without notice) are solely those of the author and do not necessarily reflect those of Finder and its employees. The information contained in this article is not intended to be and does not constitute financial advice, investment advice, trading advice or any other advice or recommendation of any sort. Neither the author nor Finder has taken into account your personal circumstances. You should seek professional advice before making any further decisions based on this information.
