Why three residential properties probably won’t fund your retirement

For many property investors, the idea of holding a three-property portfolio with a combined value of $2 million by your mid-40s is a solid base for retirement.

You’ve stuck to your strategy, bought your first investment property in your mid-30s, added a second, then a third.

The homes all have good fundamentals – good locations, quality tenants and are achieving solid capital growth, but when you sit down to map out what retirement looks like, the reality can become far less rosy.

After all expenses are paid, three debt-free residential properties worth $2 million will generate around $50,000 to $70,000 in cash flow each year, equating to a net yield of around 3 per cent, before tax.

According to the Association of Superannuation Funds of Australia, a couple needs at least $72,000 in today’s money annually for a ‘comfortable’ retirement.

Many of us though want much more than just a comfortable retirement, which could mean a significantly higher income is desired.

So, for a couple in their 40s, it may not be what’s needed in 15 or 20 years when they stop working if they want to live off the income for life.

While superannuation will also help, it may not be enough to live the retirement dream that you desire.

The uncomfortable truth is residential property is exceptional at building wealth through capital growth, but it’s generally poor at generating income.

Buying more residential properties also doesn’t solve the problem, it just gives you more assets yielding around 3 per cent.

However, diversifying into commercial property could be a solution, with commercial and industrial yields often 6 per cent or more, and you don’t need hundreds of thousands of dollars sitting in the bank to make it happen.

The blended property portfolio approach

To build that sought after base for retirement, investors shouldn’t be looking to build a portfolio that’s residential-only or commercial-only. What you need is a blend of both.

In a balanced portfolio, residential property will continue to deliver long-term capital growth as a stable investment while commercial and industrial property can generate the income you need to live on.

Commercial leases also provide an advantage, typically spanning five to 10 years rather than the standard 12-month residential tenancy agreements.

Those long-term leases provide income stability, lower vacancy rates, and with outgoings taken care of by the tenant.

There is a trade-off, however, in vacancy risk. Commercial properties can sit empty for significant periods between tenants, compared to several weeks for residential in today’s hot markets.

Investors can offset those risks by diversifying across multiple commercial assets or through managed funds that hold multiple properties.

Here’s a hypothetical case study to show how this can play out in practice.

David and Emma, both 45, owned three debt-free residential properties worth $2.1 million combined, generating $61,800 annually after expenses, with their yield coming in at 2.9 per cent.

The couple used other funds they had to invest $600,000 in industrial and commercial assets through two managed funds.

Five years later and assuming 5 per cent capital growth on the residential properties and 4 per cent on the commercial investments:

• Residential: $2.68 million value, $80,400 annual income (3 per cent net yield)
• Commercial/industrial: $730,000 value, $43,799 annual income (6 per cent net yield)
• Total portfolio: $3.41 million, generating $124,199 annually (3.6 per cent blended yield).

If the couple had invested the same $600,000 in equity into additional residential assets, the portfolio would have a similar value of around $3.45 million and generate approximately $103,000 annually.

That blended portfolio provides more income than a residential-only path, with the advantages of longer leases, tax-deferred distributions and hands-off asset management.

So how do residential investors actually access commercial property?

One of the most common misconceptions is that investors need a huge amount of capital to enter commercial and industrial markets.

While direct ownership does require a significant commitment, there are three pathways to commercial investment.

The most onerous is direct ownership, which requires around 35 per cent of the purchase price for a deposit and costs.

While the advantages include complete control over tenant selection, lease terms and property upgrades, the investor has full management responsibility. Direct ownership is best suited to experienced investors with a significant capital base and time on their hands to manage any issues as they arise.

Managed property funds are an alternative entry strategy. These funds pool capital from multiple investors, with minimum investments starting as low as $25,000, depending on the fund manager’s strategy.

Under a managed fund, experienced professionals handle acquisition, leasing, tenant management and maintenance.

A single $100,000 investment might provide exposure to five industrial properties across three cities, while funds typically offer tax-deferred distributions of up to 40 per cent, reducing annual tax liability.

Investors can also choose to add commercial and industrial property to their portfolios by buying shares in listed Real Estate Investment Trusts (REITs) on the ASX.

These REITS trade with high liquidity but are exposed to wider share market sentiment. When the stock market falls, REIT prices will often follow, regardless of the underlying property values.

Yields are lower too, typically ranging from 4 to 5 per cent, compared to 6 per cent for direct ownership or unlisted funds. REITs are best for those investors who prioritise flexibility over higher yields.

When to make the move

For first-time investors, residential remains the preferred play, with lower risk and simpler financing making it easier to build an initial portfolio.

Transitioning to a blended portfolio depends on your life stage and investment strategy. Investors in their 40s should ideally begin adding 10 to 20 per cent commercial exposure.

By the time you reach your mid-late 50s, your commercial exposure should grow to 40 to 50 per cent of your total portfolio value, with your assets now not only accumulating wealth, but providing growth plus income.

Start by analysing your current portfolio’s net yield and comparing it to what you need to live on when you retire. The difference between those two numbers is the commercial property allocation you need.

The residential portfolio you’ve built over decades is what’s made you wealthy. Commercial property is how you convert that wealth into the retirement income that actually funds the lifestyle you want.