Deciding between commercial vs residential real estate investing is not a decision that can be made overnight. Each strategy offers its own set of benefits as well as its own set of challenges. The path an investor chooses to take will depend on their goals, risk tolerance, liquid capital, and time. Review the following benefits before making your final choice.
What Is The Difference Between A Residential And Commercial Property
The technical difference between a residential and commercial property is as follows: Residential real estate is all single family homes and one to four unit rental residences while a commercial property is anything with five or more units. Condos, duplexes, and quadruplexes make up residential real estate while office, retail, industrial, multifamily (of five units or more), hotel, and special purpose buildings are considered commercial real estate.
Another stark difference between commercial and residential properties is in the type of tenant each building attracts. Residential properties are typically leased to families and individuals while commercial properties are leased to businesses.
Lastly, each property type comes with a different set of opportunities. Commercial real estate tends to award investors a much wider range of potential investment. For example, there are more commercial property investment funds than residential ones. On the other hand, residential real estate investing tends to give investors a more active role in the property.
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Benefits Of Commercial Real Estate Investing
Higher Returns: You’ve heard the saying, ”with greater risk comes greater reward,” which is quite poignantly the case with commercial properties and higher returns. Compared to the returns on residential properties, commercial property cash flow and returns are far more attractive. According to the National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index, commercial real estate investments have an annual average return of 12.7 percent compared to the S&P 500 with an average annual return of 8.8 percent over the past 15 years. More space equals more tenants which equals more money in your pocket. Not bad for an investor looking to diversify their portfolio.
Qualified Tenants: It can sometimes be difficult for investors looking to rent out their single family property (or small multi unit property) to find tenants who are qualified and who will keep the property up to snuff. Commercial tenants on the other hand tend to be businesses, corporations, or something of the like. Because they are backed by a larger company, they are typically more likely to respect the property and its rules. While this is not always the case, qualified tenants will make any property owner’s life easier.
Triple Net Leases: While triple net leases vary from case to case, they are extremely valuable for commercial real estate investors. With a triple net lease, the property owner does not have to pay any expenses on the property. The lessee handles all property expenses directly, including real estate taxes, so all the property owner has to pay is the mortgage. Big companies (think Starbucks, Target, Walmart, etc.) will typically sign this type of lease in order to maintain a look and feel that is inline with their branding. So they manage those costs while the investor pays practically nothing in maintenance costs. Talk about a win win. There are a variety of net leases that investors can adopt; however, a triple net lease is specifically a benefit of commercial properties alone.
Longer Lease Terms: Commercial leases tend to be much longer when compared to residential properties, which typically range from six to 12 months. It is not uncommon for commercial properties to lease for anywhere from five to 10 years. For investors, this means lower turnover costs and vacancy rates. The long lease terms signal reliable, positive cash flow for those worried about marketing a property from year to year. It is possible for commercial investors to end up with less than desirable tenants for extended periods of time, but with the right application process and legal protections investors can avoid and long term issues.
Easier To Increase Value: One of the biggest differences in residential and commercial real estate is the way in which property values are determined. While residential real estate is largely influenced by comparable properties, commercial real estate is more directly impact by how much revenue it generates. Simply put, the amount of cash flow a commercial property is earning the higher the property value will be. With the right tenants, investors could see an increase in value at a much faster rate than residential housing.
Smart investors know that it is of utmost importance to evaluate all the pros and cons before making a final investment decision. However, these benefits of commercial real estate investing are undeniable.
Benefits Of Residential Real Estate Investing
Cost Of Entry: While it is very possible to obtain commercial real estate loans even as a newbie investor, the cost of investing in residential real estate is most certainly less than commercial real estate — at least to start. The average person may not have enough in savings for a sizable down payment on a commercial property, while it is much more likely that they have enough saved for a single family home. If the thought of a commercial property sounds too overwhelming as a new investor, think of it this way: Once an investor has purchased several cash flow producing residential properties, they will likely have the capital and necessary experience to invest in a commercial building.
Decreased Tenant Turnover: For residential real estate investors, especially if their focus is on single family homes, tenant turnover is not something dealt with often. Businesses change and grow and those are usually the tenants that make up commercial properties. With that kind of volatility, it can be difficult to keep tenants for long periods of time. This means more work has to go into finding tenants on a regular basis as opposed to once in a blue moon. In fact, if you market and screen tenants correctly as a residential real estate investor, you can find individuals who are committed to be long term renters. If you focus on acquiring only long term tenants, you can be more confident that they will treat the home as if it’s their own.
More Lenient Zoning Laws: With commercial investing comes far more red tape to deal with as the property owner. Zoning laws are more strict, building permits are harder to come by, etc. With residential real estate, rules and regulations are not only more lenient, but also more small scale.
Larger Buyer And Renter Pool: Think about it: everyone needs a place to live, right? Residential real estate benefits from having a large pool of potential tenants and buyers when compared to commercial real estate – which relies on businesses. As companies acclimate to online marketplaces and remote work opportunities, investors may find it harder to attract commercial tenants in some markets. The high demand for residential real estate makes this a particularly attractive opportunity for investors no matter the market.
Performs Better In Economic Crisis: Business are often the first to experience the costs of an economic downturn, which can affect commercial investors in a few ways. First, commercial property owners hoping to attract tenants while the economy is in decline may find marketing the property to be particularly challenging. Residential real estate is by no means immune to these challenges; however, as a whole residential property owners will benefit from the fact that housing is always in demand (despite the state of the economy). There is also no guarantee a company will stay in business for the duration of a commercial lease. This can present a unique challenge for commercial investors counting on long term tenants.
Both commercial and residential real estate investing have positives and negatives. To decide which strategy is right for you, it’s important to review the benefits and determine which ones align more with you and your business’ core values.
Commercial Loans Vs Residential Loans
Traditional residential loans, or residential mortgages, are typically distributed by banks to borrowers. Unlike residential mortgages that are typically between banks and the individual buyers, a commercial mortgage is made to a company. For tax purposes, it is also usually in the best interest of the borrowers to sign as a representative of a business entity — since the property is zoned for businesses uses.
In addition, commercial loans are riskier (in the eyes of lenders) than residential loans. This makes a commercial loan’s interest rates higher and terms shorter. Why? Because there is a whole secondary market for commercial lenders that is separate from traditional banking institutions.
In order to qualify for a commercial loan, investors are required to have a business plan as well as a solid credit score — for the most part. Commercial lenders are more concerned with the property’s projected cash flow than residential lenders are. They will want to know who will pay utilities, what type of maintenance will be required, and more before approving the loan.
Finally, the terms, conditions, restrictions and penalties vary greatly between commercial and residential loans. Homeowners usually finance their properties over lengthy periods of time. — most commonly with 30-year fixed rate mortgages. Although residential buyers have many other loan options available, this time frame is ideal due to a longer amortization period that creates smaller monthly payments. Residential loans are typically amortized over the life of the loan so the loan is fully repaid at the end of the term. Unlike residential loans, terms for commercial loans typically range from five to 20 years, and the amortization period is often longer than the loan term. Commercial lenders are also able to customize the loan repayment schedule to each borrower’s specific requirements.
Commercial Vs Residential Electricity Rates
The quality of the energy consumed in commercial and residential properties is exactly the same. However, because commercial property owners tend to have to buy electricity in bulk, electric companies often offer discounts and different tariffs to them. These commercial electricity tariffs often allow business owners to purchase electricity at a cheaper rate because the volume that they must consume ensures that electricity companies will recuperate ample funds for their energy.
What Is Passive Commercial Investing?
Passive commercial real estate investing allows individuals to opt to invest as a limited partner with commercial real estate companies. While it is entirely possible for an investor to become a direct owner of a commercial building, the amount of capital required to do so typically makes it difficult to enter into the sphere. Rehabbing, prehabbing, and wholesaling commercial and residential properties is a great exit strategy for those looking to make a living in the real estate. However, for investors seeking a more diversified and balanced approach to real estate investing, they may be better off rethinking these strategies and, instead, opting to build a portfolio of passive commercial real estate investments.
Choosing between a commercial vs residential investment property is no easy feat to tackle, especially because both come with their own set of benefits and drawbacks. Both will diversify your portfolio, both come with significant tax benefits, and both will bring you one step closer to achieving your goals of financial freedom…So how is an investor to choose?
The answer to that questions ultimately depends on what it is he or she wants to gain by investing in real estate. Investors should take some time to think about their short and long term goals. If they are looking to make a quick buck to start, rehabbing or wholesaling a residential property might be the way to go. If, on the other hand, they are in it for the long haul and looking to achieve passive income, commercial properties offer attractive benefits.
If you want to earn the most returns, you might want to consider investing in commercial real estate. On the other hand, residential properties may be more appealing if you’re more comfortable working on a small scale. Thinking about how much time you’re willing to devote to your project as well as your risk tolerance can make it easier to decide where to invest your money.
Commercial vs residential real estate investing, which strategy will you choose? Share your answer, your story, or your experiences in the comments below!