Commercial Vs. Residential Real Estate Investing

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When someone wants to invest in real estate, they might be presented with several choices. Of these, one of the main divisions is that of commercial and residential real estate. While the two might be related, they’re quite different when it comes to investing in a property. 

If you’re confused about whether to go for residential real estate or commercial property for your investment vehicle, there are certain factors to consider. Let’s have a look at the differences between the two properties so that you can be better informed of your expected cash flow and property management: 

Commercial vs. Residential Real Estate Investing

Before we delve into the differences between commercial and residential properties, let’s define the two separately to get a better understanding: 

About residential real estate

Residential real estate is the name we give to any kind of complex that has anywhere between one to four units. These could be condominiums, single-family units, duplexes, triplexes, and quadplexes. 

Basically, residential properties or residential real estate is the kind that’s meant solely for living in. It’s meant to house families, roommates, couples, or even single people living alone. In a nutshell, this is the property that people would call ‘home’. This sets them apart from commercial real estate like hotels, etc. 

If there’s any instance of commercial activity within residential real estate, this would usually be a violation of the local zoning ordinances. 

The pros and cons of residential properties

Below, we’ll be considering the nuances of investing in residential real estate. This will give you an idea of which way to go when you’re building up your investment portfolio:

Pros 1. A lower barrier to market entry

When you compare residential properties to commercial or other kinds of real estate, there’s quite a lot of choice available. The supply of houses is high, so the price naturally decreases. This is why residential real estate is currently among the cheaper types of real estate to invest in. 

With the lower price, entering the residential property market will be easier for investors. They’d need less capital than commercial options and will have to take less risk when going for residential properties. 

What’s more, the majority of the American population has grown up on the residential property. This means that they’re familiar with this product, which is also why investing in residential properties is so popular for now.

Finally, most investors also have a lot of choices when it comes to mortgage programs for financing their real estate venture. Commercial loans are usually more difficult to obtain, at least according to some investors. 

2. A larger pool of prospects

Where there are a lot of residential properties, there are also a lot of potential residents waiting to occupy them. At any given time, there are a lot of people wanting to buy or rent a place to live.  

When the prices are reasonable, you’d find it very easy to get tenants. This is part of the reason why residential real estate becomes quite lucrative. 

Investors like house flippers will also thrive here. These are people who purchase houses, renovate them, and sell them on for a (hopefully) tidy profit. Single-family homes have a much larger buyer pool than the other kinds of real estate out there. 

3. Consistency even in an economic downturn

Since people are usually in search of a place to call home, rental properties will usually be the best kind of real estate to own. Even when there’s a depression or recession going on, this fact doesn’t change much for a residential property. 

Even if families and individuals have to cut their costs, they’d probably sell their business or other assets before letting go of their homes. So the next time you’re thinking of whether a mobile home is a good investment, consider the points above before deciding. With a commercial property, tenants might not pay up on time but be difficult to evict. 

Cons 1. A higher risk of vacancy

Buying up a lot of residential properties might seem like a tempting prospect, but you also have to consider the downsides here. One of these is that your potential tenants or buyers have a lot of choice as well. 

While there are a lot of people in the market for a place to live, it’s also true that many of them are quite picky. If you go for an area that’s not the hottest one around, your prospects are likely to move on as soon as they can afford to. This is why it’s best to go for residential properties that are already in an area that’s in high demand. This way, people won’t want to vacate their homes to live somewhere else (at least, not for a very long time). 

Of course, investing in such a popular location would cost a fair bit of money. In such cases, you’d have to be a bit prepared for difficult times. With the short residential leases, your tenants might leave in the next six months or next year. 

A real estate investor (for both residential and commercial property) can minimize such risks by having a stringent screening process for tenants. Go for triplexes or duplexes, even quadplexes if possible. This way, you won’t risk a 100 percent vacancy if a tenant moves out of a condo or single-family unit. Also, be prepared for the decreased likelihood of long-term tenants. 

2. A lower profitability potential

If your tenants move out of your residential properties, the harsh truth is that there will be a lower income for you in those empty months. Plus, you’d still have the expenses incurred by having ownership of these real estate assets. These include:

  • Tenants: the rest of your tenants will still be an expense if they cause any damage. The same goes for tenants who incurred damage before leaving. 
  • Toilets: Those visits from the carpenter, plumber, and electrician are quite costly and tend to  eat away all your profits.
  • Termites: If there are termites, or any other pest infestation, it’s essential to call in the professionals right away. You’d probably have to reach deep into your pockets for fixing such issues as well.

About commercial real estate

When we talk about commercial real estate, we’re usually thinking about the following asset types: 

  • Offices
  • Retail stores
  • Industrial
  • Multifamily units
  • Hospitality organizations

As the name suggests, commercial real estate is meant for business purposes. This is the place where you have a workspace for people who need it. 

Pros and cons of commercial real estate

Again, we need to check out the main ups and downs of investing in commercial real estate before deciding to invest in such a property. Let’s have a look at them now:

Pros 1. Longer leases

The leases on residential real estate are quite short. Some can even be for a single month, while six months or one year is usually the norm. This isn’t really good news for those who want to try real estate investing. 

On the other hand, commercial real estate has a longer lease span on average. This could be from three to five years, though many such properties also have terms lasting more than 20 years. 

A lease agreement means that the tenant has agreed to give you rent for that amount of time. When the lease term is longer, this means that your cash flow from the commercial property is also steady and reliable. 

A word of warning here, though; a longer lease on commercial property might turn on you in case the tenant isn’t a good choice. Evicting any tenant before their lease is up can be difficult, expensive, and cause a lot of problems. This is why anyone experienced in commercial real estate investing will be very thorough and structured while screening potential tenants. 

2. A lower risk of vacancies

When you’re involved in real estate investing, the cash flow from commercial property will obviously be better when there are no vacancies. With the long lease terms and potential for multiple tenants in commercial real estate, having a vacant space for too long is quite unlikely. 

Even if a tenant does decide to move on from the commercial property, the investor will likely have a lot of notice. This leeway will enable them to make the required preparations and look for a new tenant before too long. 

Most commercial real estate options would have a lot of units onsite too. With a 200-unit complex, for instance, even if 20 remnants move out, there’d still be 90 percent occupancy. 

3. A higher potential for profits

Commercial real estate requires you to deal with more square footage. This means you have more income, more tenants, and more cash flow from your commercial property at the end of the day.

4. Higher Profitability Potential

In commercial real estate, you’re dealing with more rentable square footage, which equals more tenants and more rental income; thus, more profit. 

With a lot of tenants, you’d also be able to hire onsite, full-time property management staff for dealing with the daily issues onsite. This step will free you up for other projects, whether those are related to residential or commercial property. 

Additionally, with a triple net lease or modified gross structure, the tenants are usually responsible for common maintenance and property taxes. As the owner of the commercial property, this also means that you’d have few expenses left. 

Cons 1. Relatively difficult entry into the market

As compared to residential real estate, it’s quite rare to find inexpensive options in commercial real estate. Commercial real estate properties are comparatively fewer than residential ones. Plus, they’re also very large and require a lot of capital. Not every investor is financially capable of such an undertaking, so entering that market is naturally more difficult. 

When investing in commercial real estate, you’d also have a lot of competition. There are investors with a lot of experience, REITs, and crowdfunded properties. There will also be groups with more specialized knowledge, expertise, connections, and capital than any investor who’s just starting out. All in all, you’d be at risk of losing out on a lot of opportunities to the more seasoned and major players in the commercial property market. 

2. Higher Volatility

An economic downturn could hit the real estate market at any time, so the owner of a commercial property needs to be aware of this fact. With such a decline, small businesses in the business sector usually take a big hit. When these fail, it’s very likely that your tenants would make late payments or no payments at all.

At the same time, commercial property owners will also be fighting a lot to persuade businesses to buy or lease their space when the economy is bad. Business owners and entrepreneurs are mostly aiming to lower costs at this stage. So, they’re probably not going to commit to a long lease. 

Other Considerations for Real Estate Investing

The decision about investing in residential or commercial real estate is not easy. The discussion above might have cleared your conceptions somewhat, but let’s have a look at some more considerations before you decide about your next move in real estate investing: 

Level of caution

If you’re cautious with real estate investing, it’s better to go for residential properties. These give you a relatively easy entry into the market, more stability, etc. 

However, if you want to build up a solid passive income and generational wealth, commercial real estate is the way to go. Even if you can't afford it right now, you can start small and work your way up with a bit of luck. You’d have to invest some time as well, since connections, specialized knowledge, and expertise count for a lot when dealing with commercial properties. 

Level of complexity

Residential real estate makes money for its investors in a few ways. These include equity buildup, cash flow, and appreciation. With this choice, you’d do best to read up on the common ratios such as capitalization rates, cash-on-cash return, and return on investment (ROI). This is simple enough, but investing in commercial real estate requires a bit more understanding and evaluation along with other metrics. 

When you go with commercial real estate, it’s like having a business of your own. You have to increase the net operating income here, so there should be maintenance records, rental history, and other expenses. These will usually not be in listings. Operational ratios, analysis, and other details will also be part of the deal. You’d have to look at the past year of profit and loss statements, which is just part of the time one has to put in for commercial property. 

Ease of financing

Seasoned investors seem to be a bit split about which sort of real estate investing is easier to finance. 

On one hand, some say that you can get a lot of capital for buying commercial property. Generating lower amounts of cash for buying residential real estate is relatively difficult. 

On the other hand, some say that banks aren’t too thrilled about giving loans for buying commercial real estate. This hesitation is due to the higher risk involved. 

One important factor regarding financing is that of location. Certain metropolitan areas might be booming, though others might be in a rut. 

Overall, it’s more likely that a bank will approve a loan when you already have tenants on long leases. Of course, if you already have this solid base, you aren’t likely to need a loan or sell out. 

Return on investment

With real estate investing, the most natural aim is to get a high return on investment. Most investors and investment experts end up disagreeing on this point, so you’d have to decide on what seems best for your unique situation. 

For instance, investors within a certain area might want at least a cash-on-cash return of at least 8 to 12 percent after all the considered expenses. Other areas might have to promise at least a return of 15 percent before an investor considers it profitable enough. 

Of course, the ROI will also vary from property to property. There’s no real average here; the factors to consider include the property type, location, property management costs, vacancy rate, and many more. 

Commercial property investors usually compare potential properties by checking out their cash-on-cash returns and capitalization rates. There’s some variance here according to the type of property involved and its location. However, the overall consensus is mostly that commercial investors want at least a cash-on-cash return at 10 percent or above. The cap rate should be around 8 to 15 percent before they’re worth considering for real estate investing. 

The Takeaway

So, should your real estate invest decision focus on a commercial property or residential properties? There’s no straightforward or direct answer here, as it will depend on the status of any investor as well as their end goals for this sort of investment. 

Overall, keep in mind that investing in commercial real estate requires a lot of everything: money, expertise, connections, and a lot more besides. Even if you can afford to buy a commercial property, you'd be putting the majority of your funds in one place. Unless you have a vast fortune for buying up several commercial real estate properties, this is a risky deal. 

At the end of the day, it’s probably better to go for some residential properties to start with. An average investor is more likely to have the means for obtaining several such properties within a short period, so you’d be able to diversify your investments. More investors are also likely to understand residential real estate, which increases their chances of doing well in that sector.

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