Commercial vs. Residential Real Estate Investing

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Contributor, Benzinga
May 3, 2024

Commercial real estate investing and residential real estate investing are two distinct sectors within the real estate industry, each offering unique opportunities and challenges for investors. Commercial real estate involves properties that are used for business purposes, such as office buildings, retail spaces, hotels, and industrial facilities.

On the other hand, residential real estate investing involves properties that are used for residential purposes, such as single-family homes, apartments, and condominiums. Residential properties are typically leased to individuals or families for residential use.

The decision to invest in commercial vs. residential real estate depends on various factors such as investment goals, risk tolerance, market conditions, and financial resources. Both sectors offer unique benefits and challenges, and investors should carefully consider their objectives and conduct thorough research before deciding on the type of real estate investment that best aligns with their investment strategy.

What is Residential Real Estate?

Residential real estate focuses on livable housing units, such as single-family homes, multifamily properties and mobile trailer homes. These properties tend to have long-term tenants since people need places to live.

What is Commercial Real Estate?

Commercial real estate refers to properties designated for business use. You won’t find people living in these properties, but you may find many visitors. Offices, retail stores, hotels, industrial buildings and land all count as commercial real estate.

Benefits of Investing in Residential Real Estate

Investing in residential real estate offers several advantages. These are some of the perks you can work toward as an investor.

Rental Income and Cash Flow Potential

Tenants make monthly rent payments that can cover the mortgage and other expenses. Real estate investors can build their wealth with this strategy by acquiring properties and essentially having tenants pay for them. You’re still responsible for property management and other tasks, but this approach can lead to a sizable income stream by the time you retire.

Real estate investors can raise the rent every year while making fixed mortgage payments. Eventually, your mortgage will get fully paid off, and your net cash flow will increase substantially.

Long-Term Appreciation and Value

Residential real estate properties hold value since people need places to live. The limited supply of real estate also makes residential properties useful hedges against inflation. Buying real estate in good locations and making improvements to your properties can also help with valuations. Your investment can grow considerably while you hold onto it, and that doesn’t even include the cash flow.

Tax Benefits and Leverage Opportunities

Residential real estate provides some of the best tax benefits and access to leverage. You can write down various expenses through depreciation and use a 1031 exchange to defer capital gains taxes on a recently sold property.

Leverage also presents great opportunities for investors. They can buy single-family homes with as little as 3% down, and can then receive monthly payments from tenants that cover mortgage payments and other expenses. When cash flow remains positive, real estate investors can use leverage to increase their profits. Leverage comes with risks, but it’s nice to know you can capitalize on it if you desire.

Benefits of Investing in Commercial Real Estate

Residential real estate has several perks, but so does commercial real estate. Here are some of the advantages you gain from getting into commercial properties.

Potential for Higher Returns

Commercial real estate properties tend to command higher rental rates, which can lead to higher returns. These properties tend to feature higher cap rates and yields than residential properties.

Potential for Triple Net (NNN) Leases

Triple net leases lower your costs and let you secure long-term tenants. Under these agreements, the tenant becomes responsible for property taxes, insurance, maintenance and related expenses. Tenants agree to NNN leases because it gives them more flexibility over how they can modify the property. These leases are long-term, lasting anywhere from 10-20 years, depending on the tenant.

It’s harder to raise the rent in the future, and you can outline what rent raises may look like in the NNN agreement. However, it’s a lot less work to manage a triple net lease property, and you also have much lower operating costs.

Favorable Financing and Tax Benefits

Commercial real estate properties let you access favorable financing that allow you to buy a property for as little as 20% down. Not having to pay the property’s market value to gain control over the asset makes commercial real estate more feasible for investors. This amount of leverage also makes it easier to acquire additional properties. You enjoy several tax benefits with commercial real estate, such as depreciation and 1031 exchanges.

How Do I Decide Between Investing in Commercial vs. Residential Real Estate?

Commercial and residential real estate each have their perks, but which one is right for you? This guide will highlight some of the reasons to consider one over the other.

Purpose

Commercial real estate caters to tenants who want to use your property for business-related purposes, while residential real estate is for people looking for somewhere to live. Some investors prefer working with people who want to find a new home, while others prefer corporate tenants.

Income Generation

You can make more money with commercial properties than with residential properties. Commercial properties attract businesses, while residential properties cater to people who want to settle into a new place. You can also secure a triple net lease with a commercial property that locks the tenant in for 10-20 years. You don’t have that same flexibility with residential real estate, but residential properties are less volatile than commercial real estate. An economic downturn usually hurts commercial properties more than residential properties.

Tenant Base

Commercial properties tend to have lower turnover rates since they attract businesses looking for long-term locations. Residential properties often have higher turnover rates since tenants usually seek short-term deals. You may lose a residential tenant in a year, but a business tenant can stay with you for well over a decade.

Market Dynamics

The location and economic conditions impact all types of real estate. However, economic developments have a stronger impact on commercial real estate. Business cycles impact each tenant’s ability to afford commercial space and stay in business. You also have to stay on top of the overall demand for specific industries if many of your tenants are within the same industry.

Residential real estate investors look at factors like population growth, interest rates, affordability and demographic trends when making decisions. Demand fluctuations exist but tend to be less dramatic than changes in demand for commercial real estate.

Financing and Investment

Commercial and residential real estate involve leverage that outmatches many types of investments. However, commercial properties involve more financing and more complex structures. It’s easier to get into residential real estate, but commercial real estate can be more rewarding in a strong economy.

Risk and Returns

Commercial real estate has greater potential than residential real estate, but commercial properties have more risk. Residential real estate can provide steady income since housing tends to remain in demand.

Getting Started with Real Estate Investing

Commercial and residential real estate offer great ways to get into real estate and use leverage to build your wealth. Tenants can stick around for years and make consistent monthly payments to cover rent. Real estate offers many opportunities and incredible tax benefits.

Frequently Asked Questions

Q

Which is better, commercial or residential property?

A
The decision between commercial and residential property investment depends on individual preferences, financial goals, and risk tolerance. Both types of properties can be profitable investments if chosen wisely and managed effectively. It is important for investors to carefully evaluate their objectives and consult with real estate professionals to determine which option aligns best with their investment strategy.
Q

How to know if the property is commercial or residential?

A
Commercial properties are typically located in areas designated for commercial use, such as business districts, industrial parks, or shopping centers. Residential properties, on the other hand, are situated in areas earmarked for housing, like neighborhoods or apartment complexes.
Q

Is residential property more expensive than commercial?

A
In general, residential properties tend to be more expensive than commercial properties on a per square foot basis. This is largely due to the higher demand for housing as compared to commercial spaces. Residential properties are sought after by individuals and families looking for a place to live, which drives up prices in desirable neighborhoods or cities with limited housing supply.
Q

Can a residential property be used as commercial?

A

While it is possible to use a residential property for commercial purposes, it is crucial to understand and adhere to the regulations and requirements set forth by local authorities. With the proper approvals in place, a residential property can potentially be transformed into a thriving commercial space.