A brief overview
The choice between commercial vs residential real estate investing isn’t one that can be made overnight. Both have the potential to be lucrative, but each has its downsides, and the decision hinges largely on each investor’s goals and objectives, along with their financial situation.
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When you’re ready to dip your toes into the big pond of real estate investing, one of your first decisions will be whether to invest in commercial or residential real estate. There are merits to each option, as well as drawbacks to both. Each choice offers a unique set of objectives, which can be achieved in different ways. However, the choice depends on your investing goals, risk tolerance and available time. Here’s an overview of commercial vs residential real estate investing to help you decide which path is best suited to you.
What is the difference between residential real estate investing and commercial real estate investing?
Let’s start with discussing the difference between commercial and residential real estate.
Commercial real estate: This refers to properties that are used for business purposes. This includes properties used for retail, industrial purposes and offices. Commercial properties include the likes of warehouses, offices, movies theaters and so on.
Residential real estate: This refers to properties that are created and used for the purpose of living. They’re usually occupied by renters and not owners, and encompass the likes of single-family homes, apartments or condos, townhouses and so on.
Residential real estate investing, as the phrase suggests, involves purchasing any of the residential property types mentioned above. Those who are just beginning their real estate journey often take the first step with residential real estate investing.
While commercial real estate investing involves purchasing any commercial real estate, giving investors a wider selection of investment opportunities. Investors who are more experienced typically choose commercial real estate, however this isn’t always the case.
Advantages of residential real estate investing
Low barrier to entry
Residential real estate is easier to get into, which is why many beginner real estate investors choose to start here. This is because individual investors can often fund their own residential property purchases, or at least put a down payment on one, as these properties are more affordable.
Easy to find tenants
Finding tenants for residential properties is never going to be very difficult, so this is one struggle that residential real estate investors won’t usually face. However, it’s important to screen tenants correctly before they sign the lease, so that investors don’t end up with defaulting tenants. Thanks to the pandemic, more people are working from home which means that the residential market has a higher demand, and for investors this means that renting out a property or finding a buyer for it won’t be too difficult.
Short leases
Residential leases are usually 12 months but can be as short as 6 months. This can be a benefit for investors as they can adjust the rent every year to match market conditions.
Easy financing
When it comes to raising money for residential real estate investing, there are a variety of options for financing, from conventional loans to FHA loans to Fannie Mae. These are easy to find and apply for, but bear in mind, they usually require down payments of 25%.
Simple maintenance
Residential property maintenance is relatively straight-forward, and repair jobs can usually be taken care of by a handyman or property manager. Getting these small repairs and maintenance jobs done is easy and more cost effective than any commercial property maintenance would be.
Continuous demand
There will always be a demand for residential property, and this includes times of economic crisis, which has been proven recently with the Covid-19 pandemic. Which means that it’s a more stable investment than other areas which are impacted by the economy.
Disadvantages of residential real estate investing
Higher vacancy rates
Residential property has a higher chance of vacancy due to the short nature of the leases. It also means that investors will get no money while the property stands vacant. Residential property is also more prone to defaulting tenants than commercial property.
Rental laws
The laws around renting residential properties are stringent and often protect tenants more than landlords, which can be a problem for investors. For example, during the pandemic, it became difficult to evict defaulting tenants, which can leave landlords unable to cover their own bills as a result of the lack of income.
Limited revenue
Residential real estate investing only offers one stream of income per property, and it’s not possible to add a large amount of value or additional income streams to these properties. Home improvements can be done to generate a slightly higher rent, but the improvements will need to be done when the property is unoccupied, which means months of rent will be lost.
Advantages of commercial real estate investing
High return on investment
Commercial property cash flow returns are higher than residential returns, however with higher returns comes higher risk. Commercial real estate offers investors the chance to make profits to the tune of 12.7% annually on average, according to the National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index. It stands to reason that the returns would be higher simply based on the fact that commercial properties are larger and house more tenants, so investors can generate a larger income.
Longer leases and more stability
Commercial real estate leases are typically longer than residential leases, ranging from 5 years to 10 years, instead of 6 to 12 months like residential properties. This means that investors are guaranteed income for a longer period of time as tenants are locked into their lease, and there’s a lower likelihood of frequent turnovers or vacancies.
Reliable tenants
Unlike residential real estate, commercial real estate tenants tend to be more reliable because they’re usually businesses. This makes tenant screening easier and gives investors less chance of tenant defaults. Commercial tenants are often more stable and less likely to get out of a lease early, which bodes well for investors who get continuity as a result of this.
Triple net leases
Commercial properties offer investors a unique selling point which is triple net leases. These allow investors to get out of paying property expenses because the tenant has to handle all the expenses. These expenses include property taxes and any maintenance costs. It’s common for big brands to sign a lease like this so that they can have the building however they choose. For investors, this is a big win and decreases their risk by a long way.
Increasing value is easier
A commercial property’s value is calculated by the net operating income that the property generates. Which means that it can be easier for investors in the commercial real estate space to increase this value, by finding the right tenants and making the right improvements to the property.
Extra revenue options
The beauty of commercial real estate is that rent isn’t the only way for investors to generate income. So, investors can expand their options by adding revenue streams to their properties, such as laundry services or vending machines. This creates extra passive income which can only help cash flow and profits.
Disadvantages of commercial real estate investing
Large upfront costs
Given the large nature of the buildings, commercial real estate costs a lot more than residential real estate, which means that there’s a much larger capital outlay. New investors often can’t foot this bill, so it usually seasoned investors who enter the commercial real estate investing game. Down payments are between 20% and 35% of the cost of the property, which is a hefty amount, not to mention the operating costs of such a building.
Higher risk
With great reward comes great risk, and commercial real estate investing offers both. The risk comes with the fact that commercial properties are accessible by the public, leaving it vulnerable to things like theft, vandalism and employees being injured on duty. Commercial real estate also has a bigger risk for tenants defaulting, and while it may not be as common, when it does happen it’s a bigger problem.
Harder to find finance
Due to the risky nature of commercial real estate, it’s harder for investors to find financing as loans tend to have high interest rates and longer loan terms to mitigate the risk for lenders. Lenders often only lend money to investors who have successfully owned commercial property before.
Difficult to sell
Selling a commercial property can take a long time because there are limited options amongst buyers. Only investors will be able to purchase a commercial property which means that it can easily take a year or more to find a buyer. So, for investors who are in a bind and need to sell quickly, owning commercial property will make this difficult.
Impacted by economic events
Commercial real estate is at the mercy of economic events such as pandemics or recessions. This is because businesses may not be able to afford to rent a building anymore, and this in turn impacts the investor’s returns.
How to invest in your first residential property
Know the market
Getting started with residential real estate begins with learning the market, which means looking for an area that has a strong potential for making a profit. This means finding a housing market that is strong, in an area that suits you.
Pick your strategy
The strategy that you choose will determine the next steps that you take. In other words, if you choose to invest in a rental property versus a fix and flip property, this will dictate the type of property you’re looking for and therefore where you look for it.
Finding a property
Your next step is to find properties and evaluate them to figure out which would be a good deal. Work out the potential return on investment for each property and decide if this would be worth your while or not. You can use a real estate agent or any one of the various online platforms such as New Silver’s FlipScout, to find a good deal.
Apply for funding
There are many options for residential real estate investors to find funding, from hard money loans to conventional loans. You can present your deal to a lender and apply for financing. Once you’ve been approved, you can move towards closing, which means that your residential real estate investing journey has officially begun.
How to invest in your first commercial property
Step 1: When we talk about how to invest in commercial real estate, the first step on your journey is to get on top of market trends and decide which type of financing you’ll be going with. You have various options, from crowdfunding to commercial bank loans to private equity.
Step 2: Choose a sector that you’d like to enter, for example office buildings. This will help you figure out the type of property you’d like to buy, the supply and demand for this property type. and how you can invest in it.
Step 3: Find opportunities in your chosen sector, via a commercial real estate broker, or other platforms such as Loopnet. Analyze each deal based on its current performance, Net Operating Income (NOI) and capitalization rate.
Step 4: Choose a property and submit a Letter of Intent (LOI), where you inform the seller of what you’re intending to purchase and what the terms will be.
Step 5: Find your financing via your chosen funding vehicle and make sure that you have a business plan ready for the lender to scrutinize.
Step 6: Do your due diligence and inspections on the property before closing, and this includes verifying information about the property such as rental rates. Once this is done, you’ll be able to secure your financing and close on the property.
Final thoughts
The biggest difference between commercial and residential real estate investing lies in the goals you have for your investing journey, your knowledge base, and your access to capital. If you’re just starting out, you may want to consider getting into residential real estate investing first, to get a feel for how it works and then branching out to commercial real estate. Either way, there are pros and cons to both, so do your homework first so that you can make an informed decision.