“Don’t put all your eggs in one basket” is a popular saying, used all over the world, which perfectly summarises the importance of the concept of investment diversification when creating a portfolio.

As an investment principle, diversification is all well and good. As many investors know there are clearly different layers of diversification – one asset class to another, further diversification within an asset class and diversification from specialist knowledge and expertise.

One of the fundamental reasons for diversifying an investment property portfolio is risk mitigation.

The real estate market is not immune to fluctuations. Different factors, such as economic conditions, local market dynamics, or unforeseen events (like a pandemic) can impact property values and rental income. By diversifying, investors reduce their exposure to the risks associated with a single property or location.

Many people who invest in residential property do so to diversify away from equities or managed funds. Few gain exposure to commercial property, missing out on further diversification benefits and opportunities.

This is despite many investors recognise the importance of diversifying their property portfolio in spreading risk, taking advantage of different wealth creation tactics and gaining exposure to alternative markets.

As an asset class, commercial property behaves differently from the residential market in many aspects, but when combined into a diversified property portfolio, these differences can also support the evolving needs of investors.

So, what are the key characteristics of the two asset classes?

Residential property has historically recorded higher growth rates than commercial property.

Most property investors will start in the residential sector, with the idea being they will leverage capital growth from these higher-growth properties to build and expand their portfolio.

From a cash flow perspective, residential properties will generally provide a lower rental return than commercial assets, with the typical net rental income ranging from 3-4 per cent.

This is in part because of the high proportion of costs borne by residential landlords, such as maintenance, rates and insurance.

While many residential investors will focus on long-term capital growth as their primary wealth creation strategy, investors with a higher risk tolerance can also look towards more aggressive equity-building strategies such as property development to accumulate wealth across a shorter time.

Focus on cashflow

Commercial property behaves differently from residential. It typically has a stronger focus on cashflow and more consistent long-term returns.

Commercial assets are also valued differently based on the income return they provide to investors – known as the capitalisation (or cap) rate.

The higher yield of commercial properties is largely due to the fact commercial investors are able to pass on their rental outgoings as part of their rental rates, with tenants typically responsible for expenses such as council rates, utilities and maintenance.

Another reason commercial property is often an attractive option for yield-focused investors is the length of commercial leases. While the typical length for residential lease agreements is about 12 months, it’s not unusual for commercial properties to have an initial lease term of five years and often more, with the option to extend this further after the initial term.

The fundamentals

There are understandably several roadblocks that prevent investors from gaining exposure to the commercial sector. With high-quality commercial assets typically priced in excess of $5 million, the high entry costs mean that few investors have the financial capacity to buy directly.

Demand, particularly for industrial property, has surged in the past few years and the entire commercial property market is expected to reach $363.4 billion this year and grow at 3.07 per cent a year to $415.5 billion by 2028.

The fundamentals for successful commercial investment boil down to location, nature of the property (office/industrial etc), supply/demand within those sectors, construction, including earthquake strength, current rentals to market, alternate uses of the property, and is the property fit for purpose (ie an older industrial property may not have the floor loading and stud height to deal with existing requirements).

With more investors recognising the strategic benefits of diversifying into commercial property, they are turning towards joint investment opportunities as a means of overcoming these high barriers.

Commercial property funds can offer investors the opportunity to enjoy the asset performance of larger and high-quality commercial assets with the benefits of lower barriers to entry and the guidance of a professional management team.

Tauranga-founded unlisted commercial property fund manager PMG says commercial real estate presents a solid opportunity for investors looking for regular cash returns and the potential for value growth, which typically hedges well against inflation over the long-term.

PMG chief executive Scott McKenzie says unlike residential properties, commercial assets often come with longer lease terms and higher rental yields, providing a more predictable income stream and lower tenant turnover rates.

Combining property types

Property investment company Erskine Owen, based in Auckland, has clients who own residential and commercial and have also invested in its property syndicates.

Erskine Owen director Alan Henderson says it’s helpful for investors to have this diversification because each sector has a different profile.

McKenzie says by combining different property types in a portfolio, an investor creates a more consistent cashflow. Even if one property experiences a temporary vacancy or rent reduction, the income from others can help offset the loss, ensuring there is a steady stream of revenue.

He says this income stability is especially important for property investors who rely on rental income to cover mortgage payments and other expenses.

If something goes wrong with a residential property, Henderson says the owner/landlord is responsible for all the expenses, whereas in commercial property those costs fall back onto the tenant.

That gives diversification away from risk, he says. Diversifying geographically is also important, Henderson says.

He points out that within commercial property it pays to have a spread of investments across a mix of properties in the industrial, office and retail sectors to give access to bigger properties and potentially better-quality tenants. “It reduces risk because what diversification is doing is diversifying an investor’s risk profile as well.”

McKenzie backs up the risk factor. He says investing through diversified property funds gives direct exposure to multiple commercial properties typically spread across different geographies, sectors and tenants.

This contrasts with syndicates, for instance, which typically own a single property or a small number of properties, often with higher gearing than funds.

“Should something not go to plan from, say, tenant default or vacancy, the impact on the syndicate income and overall asset value is naturally far greater, where there are often less levers to pull to solve the problem. Diversified funds offer investors the opportunity to gain access to the benefits of investing directly in commercial property with less risk.”

Henderson says when buying property for syndication, yield is also important. Erskine Owen has recently picked up a Countdown property at 9 per cent and other properties for 8 per cent, all on net yield. “In residential, investors would be lucky to get 4 per cent gross. When expenses are taken out it is more like a 3 per cent yield.”

High barrier to entry

To get a decent commercial property, individual investors have to pay $5 million-plus and that is far too high a barrier for most. While there are properties in the $1 million-plus range, competition is fierce.

He says the more an investor can spend, the better quality of tenant they will get. By clubbing together with friends, some investors can spend a reasonable amount on a commercial property. “That is pretty much how property syndication started. An investor says to a few mates, ‘why don’t we join together and buy the property together?’ It expands from there.

“That’s where property funds or syndicates come into their own because $50,000 will get investors into many syndicates, particularly wholesale investors. What investors are buying is the property’s income stream.”

He has found that once clients dip their toe into the commercial property water they don’t go back. Mostly, investors keep their residential holdings but find commercial is more interesting and they can do more with it once they get their head around it.

“The potential for growing value is huge. Commercial investors don’t have the same tenant headaches as they do with residential, and they can move into generating a passive income.”

Henderson says many people still believe buying residential is high yielding and the best strategy for investment. “That’s a fallacy and they get led up the garden path.”

It’s not that residential property is delivering really bad returns. “There are some great properties selling at great profits. It’s just when they are rented, they are returning only a 3 per cent yield. Serious investors get frustrated, start to look about and see they can get a 6 per cent-plus return on commercial property.”

However, Henderson is seeing a few, but not many, residential investors selling and moving into commercial property. Where it is mainly happening is when investors are approaching retirement and want a passive income.

Property funds and syndication give residential investors, who are giving up work, the opportunity to diversify without having to have a massive deposit to buy on their own or with others.

Another benefit, says McKenzie, is tax efficiencies these funds provide. This can enhance net returns to investors when contrasted with other investment products. PMG’s retail funds, for example, are all multi-rate Portfolio Investment Entities (PIE funds), which means investors pay tax on income derived from the fund, capped at a maximum of 28 per cent.

Riding it out

Savills Real Estate head of industrial sales and leasing Paddy Callesen says syndicated and unlisted funds serve a good purpose.

While syndicates have had a chequered history, Callesen says four out of five times the property market is either okay or good. “This is one of the 20 per cent of times there is a bad market and some syndicates and unlisted funds have stopped distributions as high interest rates, lower property valuations and costs have caught up with them. It’s difficult for investors because the syndicates and funds are mainly illiquid and that is the risk when investing.

“There will always be times they are not performing and investors just have to ‘guts’ it out until the tenancy is renewed, the rents have been reviewed and the market’s a bit better – everything is in alignment – so they can sell their units or shares or go to the syndicator and say, as a collective, we think now is the right time to sell the property. It’s all about risk and reward.”

Some syndicates have ridden the hard times and are now listed property funds, with investors becoming shareholders who have liquidity by being able to sell their shares.