Should I Invest in Commercial or Residential Real Estate?

Prologue

Real estate is a great investment for a number of different reasons. It’s usually safe, it adds diversity to your portfolio, and it’s known to produce great returns.

If you’re thinking about purchasing a property there’s always the question of commercial vs residential real estate. While there are some similarities between the two they’re also very different in a number of ways. Both have their benefits and drawbacks, so it’s important to look at each and decide which one better suits your investment strategy.

Pros of Investing in Residential Real Estate

Residential real estate generally applies to single-family homes and two to four-unit residences. This includes detached homes, townhouses, cottages, condos, duplexes, and quadruplexes.  While commercial real estate can be very lucrative, the benefits of residential real estate can’t be ignored. Depending on your needs this may be the better fit for your portfolio.

You Need Less Money to Start

We often get asked, “Is commercial property cheaper than residential?” It depends on the property, but in most cases the answer is no.

If you’re starting with a smaller budget then residential real estate will likely be your best option. Residential properties are usually smaller and less complex, making them easier to afford and more accessible for the average investor.

When it comes to commercial loans vs residential loans, you may also have an easier time getting financing for a residential property. This is because commercial loans are often considered to be riskier.

This is why many investors start by investing in residential first. They start with one property, and gradually add more. Then, once they get comfortable with the process of investing in real estate and have enough cash flow they move on to commercial real estate.

Are you interested in purchasing commercial properties but aren’t sure you’re ready? Investing in residential properties could be a great way for you to learn how real estate works and will allow you to save up the funds you need for your first commercial investment.

There are More Buyers and Renters

When it comes to commercial vs residential real estate, one distinct advantage that the residential market has is that there’s a larger pool of buyers and renters to draw from.

Because the barriers to entry are much lower for residential properties there are always more people looking to buy than you’ll find in the commercial market. This is very beneficial if you find yourself in a situation where you need to sell a property fast.

There are also more people looking to rent residential units, meaning you’re less likely to have issues with vacancy. It’s not uncommon for landlords to spend six months or more trying to fill a commercial space, whereas residential spaces are usually rented within 30 days.

The fact is, while not everyone owns a business everyone needs a place to live. So, selling and renting a residential property will always be easier.

It’s More Likely to Hold its Value During an Economic Downturn

Economic downturns are hard on everyone, but they’re particularly hard on small businesses and retailers. And this can spell trouble for commercial landlords.

The longer leases usually seen in commercial real estate provide some protection, but these contracts won’t help much if a tenant goes out of business and is no longer able to pay their rent. When the economy is hit hard it can also be difficult to find new tenants, as there aren’t many people looking to start new businesses.

This isn’t to say the residential market isn’t impacted by an economic crisis. As a landlord, you may have trouble collecting rent during these times. However, people will still need a place to stay meaning it’s far less likely that tenants will just up and leave.

Because of this, residential real estate usually fairs much better when the economy is down.

Cons of Investing in Residential Real Estate

Less Reliable Tenants

One thing that’s often difficult about being a residential landlord is finding good tenants.

When you’re renting out commercial real estate you’re usually dealing with companies and business owners, many of whom are backed by larger companies. This isn’t the case with residential properties. Many residential tenants will be living paycheck to paycheck, so it’s more likely they’ll miss a payment.

Commercial tenants are also more inclined to maintain their units, since it’s good for business. Unfortunately, residential renters don’t have the same motivation when it comes to maintenance and cleanliness.

The fact is, references are easy to fake so it’s impossible to know how someone will treat your property until they’re actually living there. Background checks can help weed out unsuitable tenants, but if you’re renting out residential properties you’ll inevitably run into some renters who will cause you some problems.

Lower Returns

In most cases, residential properties have fewer tenants and lower rates. So, while they’re cheaper to purchase they also don’t deliver the kinds of returns that commercial properties do.

Many residential investors purchase several properties to increase their revenue. Of course, this results in more work and you may even have to hire additional staff to stay on top of all of your properties.

This is why many investors look into commercial real estate once they’ve gotten to the point of owning multiple residential properties. One commercial property can usually generate the same income as several residential ones, and because all your tenants are located in the same building it can be easier to manage.

Pros of Investing in Commercial Real Estate

Commercial real estate can refer to a number of different types of properties, including office buildings, retail spaces, industrial buildings, and vacant lots that are zoned for commercial use. The benefits of commercial real estate investing are great, but there are definitely a few things you need to be aware of before you jump in.

Potential for Higher Returns

When it comes to residential vs commercial real estate investing, the biggest difference might be the returns. Commercial properties will almost always deliver a higher return on investment.

The main reason for this is that in most cases a commercial property has more tenants. For example, if you own an office building you may have a dozen different businesses renting space from you. The more tenants you have, the more rent you can collect and the more money you can make.

As a commercial landlord, you’ll also likely be able to charge higher rates. This is especially true if your property is located in a very desirable area. The fact is, businesses generally have deeper pockets than ordinary people and are willing to pay more for a location that could help their business make more money.

Longer Leases

The average commercial lease is three years, and leases that last as long as 12 years aren’t uncommon. This is much longer than the typical residential lease that lasts just one year.

So, why would you want a longer lease?

• More Reliable Cash Flow: Having a long lease means guaranteed money coming in for those years (assuming there aren’t any issues with the tenant). This makes it much easier to run your business and plan for the future.

• Less Vacancy: One of the biggest factors that can negatively impact your income is vacancy. When you have units that aren’t being rented you’re essentially losing money. Long leases help keep vacancy down, making it easier to keep all of your units rented.

• Less Tenant Turnover: Every time a tenant leaves it creates more work for you. You have to market the property to potential tenants, hold showings, and help new tenants get settled in. Less turnover means you’ll spend less time on these tasks and more time running your business.

Of course, a longer lease may be an issue if you end up with a tenant you’re not happy with. But assuming your lease clearly defines both parties’ rights and responsibilities you shouldn’t have any trouble getting out of it if you need to.

It’s Easier to Increase the Value of Your Investment

While rental income is nice, the greatest returns from a real estate investment come from the increase in value over time. So, investors should always be looking to improve their properties in ways that will help increase the value on the market.

While you can make improvements to residential real estate, your options are somewhat limited. Residential property values are determined largely by the price that similar properties in the area sell for. While renovating a bathroom or adding new flooring can help the value, on the whole the impact is rather small.

On the other hand, commercial real estate values are determined primarily by the amount of revenue they can generate. This means that any upgrade that improves cash flow can have a big effect on the value of the property.

Some simple improvements that can be made include:

• Increasing rents.

• Decrease expenses.

• Adding amenities that make the property more desirable to tenants.

• Adding additional revenue streams, such as charging late fees, charging tenants for parking, or renting storage lockers.

Cons of Investing in Commercial Real Estate

Higher Costs

Of course, with more revenue inevitably comes more expenses. Commercial properties are generally larger operations with more sophisticated infrastructure. This means there are more costs involved in maintaining the property.

Many commercial properties employ a number of staff, including a property manager, maintenance people, and cleaning crews. Then there are the costs associated with repairs and the general upkeep of the building.

Some of these expenses and labor can be mitigated by a triple-net lease. With this kind of lease, the tenant takes care of the property and assumes the cost of repairs and maintenance, property taxes, and insurance.

While a triple-net lease generally means you won’t be able to charge as much for rent, it will reduce your responsibilities and expenses, so it’s definitely worth considering.

It’s More Complicated to Evaluate a Commercial Property

When it comes to commercial vs residential real estate this may be one of the most important things to consider.

As we mentioned earlier, valuing residential real estate is relatively simple. If you can find a similar property in your area that has sold recently then the sales price should more or less apply to the property you’re looking at, plus or minus a few factors.

However, valuing commercial real estate involves a number of different variables. This includes:

• Net operating income

• Cap rate

• Gross rents

• Vacancy

• Zoning

• Location

Of course, this is what commercial real estate brokers are for. If you partner with the right one they can walk you through all of this and help you come up with a valuation. Just be prepared for a more complicated process.

Commercial vs Residential Real Estate: Which One is Right for You?

Are you not quite sure which investment is the right choice? Here are a few tips to help you choose the best property for your portfolio:

Residential Real Estate is Right for You If:

• You’re a first-time investor

• You have a smaller budget

• You need to find tenants quickly

• You’re looking for a safer investment

Commercial Real Estate is Right for You If:

• You’re an experienced investor

• You have a larger budget

• You can afford to wait a little longer for the right tenants

• You want to earn the highest return possible

Conclusion

Investing in real estate is a smart move whether it’s residential or commercial. When deciding which market to enter, consider your finances and choose the option that best aligns with your goals. If you’re still unsure, seek advice from industry experts. They’ll be able to guide you towards the decision that’s the best fit for your needs.