Experienced real estate investors understand that owning income-generating properties can be a powerful addition to their investment portfolios. Residential and commercial properties have served as common real estate investment holdings for a long time. However, in recent years, there has been a change in preferences towards mixed-use real estate—properties that house both residential and commercial assets.
Mixed-use properties are developments that combine different types of real estate, such as residential, commercial, and retail, within a single project. This integrated approach offers residents convenient access to amenities, services, and employment opportunities within their own community.
According to a 2023 survey by The National Association of Realtors, 78% of Americans said they would be willing to pay more to live in communities where shops and parks are closer to their home.
This trend is driven by the appeal of living in vibrant communities while saving on time and the costs of long commutes. Many businesses also prefer establishments closer to populated areas, allowing them to remain near their customers and potential workforce.
Mixed-use facilities are becoming increasingly popular among investors due to their potential for diversified income streams and growing demand in urban areas. Still, like other investment strategies, mixed-use properties also come with their share of perks and drawbacks.
In this guide, we’ll explore the key aspects of mixed-use properties, including their benefits, challenges, and potential implications for investors. We’ll delve into the unique characteristics of these developments, discuss factors to consider before investing, and provide insights to help you make informed decisions. By the end, you’ll have a solid foundation for understanding mixed-use real estate and be better equipped to assess their suitability for your investment portfolio.
What Are Mixed-Use Properties?
A mixed-use property is an investment property that combines multiple asset classes (such as residential, commercial, and office properties) within the same establishment.
Mixed-use properties appeal to tenants and business owners by providing the everyday things they need within walking distance. For example, a mixed-use property with retail stores on the ground level and apartments on the top levels allows tenants to live and shop at the same location. Likewise, a mixed-use property with office spaces on the lower floor and residential units on the top floors allows business owners or worker tenants to reduce commuting time to their workplace.
There are several benefits of investing in a mixed-use property, including:
- Diversified Income Streams: Investing in a mixed-use property can generate income from multiple sources, including tenants living in residential units and businesses operating in offices and retail spaces. This diversification across property types helps mitigate risk by reducing reliance on a single income stream. If one asset underperforms, the other portfolio assets can potentially offset those losses, providing a more stable overall investment.
- Potentially Higher Yields: Residential, retail, and commercial property types are priced differently in a mixed-use investment property. Property owners typically charge higher rates for retail and commercial units, providing greater returns compared to owning a single-use property.
- Attractiveness to Buyers in Urban Markets: The prospect of living, working, and playing at the same place without the need to travel long distances appeals to many tenants. They save time on the commute and become more productive when their home, retail stores, fitness facility, entertainment spaces, and work location are within walking distance. From a business owner’s point of view, a mixed-use establishment located closer to a dense population helps them more easily attract customers and potential workforce.
While mixed-use properties offer attractive potential benefits, they can also be complex to acquire and manage. The diverse nature of these developments requires expertise across multiple real estate sectors, and the operational aspects can be demanding.
For investors seeking a more passive approach to mixed-use real estate, Delaware Statutory Trusts (DSTs) can provide a compelling solution. DSTs offer fractional ownership in professionally managed mixed-use properties, allowing investors to participate in the potential benefits without the direct responsibilities of property management.
Managing Mixed-Use Rental Properties
Mixed-use properties offer a potentially profitable investment opportunity for real estate investors. However, it can be challenging to manage these types of properties. It requires a thoughtful approach that considers the needs and requirements of each type of tenant.
- Residential vs. Commercial Preferences: Residential tenants may prioritize quiet, comfort, and amenities like parking, whereas commercial and retail occupants might seek visibility, foot traffic, and utilities. This difference of preferences could result in conflicts, such as noise from commercial activity may disturb residents.
- Rent Pricing: Properties in the same location may be charged different rent. Since commercial properties have a higher income potential, they are typically charged higher prices than residential properties, which are typically priced based on affordability and livability.
- Marketing: Property owners need different marketing approaches to find tenants for each property section. Buyers interested in commercial properties can be found through business networks and online platforms, while it may be better to advertise residential units through real estate listings and social media.
- Maintenance Issues: Managing a combined-use property brings unique maintenance and repair challenges. It requires coordination of plumbing, electrical, and heating for both commercial and residential sections, and any interruption can affect the activities and experiences of both types of tenants.
Therefore, it is important to schedule repairs and maintenance to minimize disruptions and ensure the property remains functional and attractive for everyone.
Tax Implications of Mixed-Use Properties
Owners of mixed-use properties can utilize tax benefits to manage costs and reduce their liabilities. However, unlike single-use properties, these properties contain different types of properties, each with different tax treatment. For example, commercial properties are often taxed at a higher rate compared to residential units.
Mixed-use properties present tax and regulatory challenges that differ from residential or commercial properties. To ensure compliance with tax laws and regulations, property owners must account for property value, income, and expenses for each property type separately. Each property type produces multiple transactions, including rental payments, maintenance costs, appraisal fees, utilities, and insurance.
Experienced property owners and managers keep different accounts for each property type to prevent mixing funds and make it easier to track cash flow.
When you own a mixed-use property, you can claim different deductions to reduce your tax liability. These include:
- Deduct the cost of wear and tear for different property sections from your taxable income. Under IRS rules, if 80% or more of gross income generated from your property comes through collecting rent from residential occupied units, you can depreciate the entire property over a period of 27.5 years. To put this into perspective, non-residential properties are depreciated at a relatively slower rate of 39 years. Simply put, you can claim larger deductions in the first years of owning primarily residential property.
- Multi-use property owners can claim tax deductions for expenses relating to maintenance and repairs of the property.
- Owners can claim tax deductions on interest payments made on debt to acquire or improve a mixed-use property. As mortgage payments are structured to charge higher interest payments in the early years of the loan, this deduction is particularly valuable in the initial phases of property ownership.
- State and local tax treatment for each property type may vary. Property owners must be aware of state and local regulations to avoid penalties, missed deductions, or overpayments.
1031 Exchange Opportunities for Mixed-Use Properties
Experienced real estate investors often consider a 1031 exchange strategy to enter and exit a commercial real estate investment. A 1031 exchange allows investors to defer their capital gains tax liability when they sell a business or investment property and reinvest the sale proceeds into another like-kind property. This approach helps them use the total dollar amount received in a sale to purchase a new, potentially more profitable property.
1031 exchanges can also offer an opportunity for real estate investors to diversify or consolidate their property holdings. Whether you are looking to exchange your mixed-use property for multiple commercial or residential properties or seeking to unify multiple investment properties into a single asset, a 1031 exchange can be an effective strategy to achieve your investment goal while deferring capital gains tax.
Here are the most prominent 1031 exchange requirements taxpayers must meet to perform a property exchange:
- Business or Investment Purpose: The primary requirement for a property to be eligible for a 1031 exchange is that both properties, the relinquished property and the replacement property, must be held solely for the purpose of investment or business operations. Personal property, such as a primary residence, does not qualify for tax deferral treatment.
As a caveat, if the property owner has occupied a portion of the property for personal use, they can exclude that section and perform the 1031 exchange on the rest of the property.
- Strict Timelines: The seller of the property must identify a suitable replacement property(ies) within 45 calendar days of the sale of the original property. They must also acquire the replacement property(ies) within 180 calendar days of selling the original property.
- Equal or Greater Value: In order to defer 100% of capital gains tax, investors must acquire a replacement property (or properties) of equal or greater value than their original relinquished property.
- U.S. Location: Both exchange properties must be located within the United States.
- Qualified Intermediary: An exchanger cannot take possession of the sale proceeds from the sale of the original property. Instead, they must engage a Qualified Intermediary (QI) to hold the exchange funds and purchase the replacement property on the taxpayer’s behalf.
Risks and Challenges of Investing in Mixed-Use Properties
Mixed-property developments can be complicated investments for several reasons, including
- Market demand variations: Mixed-use properties house different types of tenants with varying needs under one roof, and the design and construction of the property needs to meet tenant demands. For example, noise from commercial activities should not reach residential premises, and the use of parking space by residential tenants should not burden the parking availability for customers in commercial and retail areas. A mismatch between the demands of different types of tenants can result in conflicts and ultimately affect the investment’s returns.
- Zoning and regulatory compliance challenges: Mixed-property owners need to fulfill the local zoning and regulatory requirements for each type of property. Some municipalities have strict zoning rules related to parking requirements and building heights, which may frequently disrupt operations or restrict an investor’s ability to utilize particular property sections.
- Financing complications: It can be difficult to secure financing for mixed-use properties compared to single-use projects. Sometimes, financial institutions don’t provide lending for certain property types, whereas others consider investments with varying income streams a higher level of risk. Moreover, the prospect of dealing with multiple types of tenants in one building might deter lenders from offering loans.
- Property management complexities: You need a long-term maintenance and management strategy to address the varying needs of different property types. These properties need regular upkeep and specialized expertise to preserve the property’s value and ensure tenant satisfaction.
Key Tips for Investing in Mixed-Use Properties
Owning and running a mixed-use property can be a worthwhile investment if you do proper preparation and due diligence. Here are some ways you can navigate the complexities of mixed-use investments:
- Conduct thorough market research: Before investing your capital, you must ensure that the property meets the needs and requirements of each prospective tenant type. Start by visiting similar properties and communicating with commercial and resident occupants about the facilities and amenities they find useful and valuable. You can compare these factors with your potential investment candidates to validate if they match your requirements.
- Evaluate location-specific demand for mixed-use spaces. Mixed-use developments appeal to tenants and businesses seeking convenience and proximity to shopping and entertainment spaces. Ask yourself if there is greater foot traffic from residential to commercial areas in an area that can be reduced by offering both services under one roof. Can you provide an attractive residential and business facility that satisfies different types of tenants without each affecting the other’s experience?
- Budget for potential challenges in management and upkeep. Maintaining and managing a mixed-use property can have unforeseen expenditures as you have to cater to the expectations and demands of diverse tenants. There are also costs associated with ensuring compliance with municipal zoning laws for each property. Property owners should budget accordingly for these payments to ensure smooth operations.
- Work with experienced property managers or real estate agents familiar with mixed-use properties. A professional management company experienced in handling mixed-use properties can help you better navigate ownership challenges. Likewise, you can speak to a real estate agent to understand the issues you could face with these investments. They help you answer questions such as:
- Should you combine residential properties with office buildings or retail stores?
- Do the local zoning laws allow you to create a vertical mixed-use property (different property types in the same building)?
- Can you sidestep a zoning limitation by investing in horizontal mixed-use developments (different property types adjacent to each other)?
Consider Mixed-Use Properties for a Strategic Investment
The appeal for people to live, work, and shop at the same location makes mixed-use investments financially rewarding for investors. Owners of mixed-use properties are able to diversify their income sources and investment holdings and optimize their tax liabilities.
Investing in a mixed-use property exposes you to challenges and risks related to each property type. Like other real estate investments, you can better navigate these issues by understanding tax rules, the demands and needs of tenants, and learning about your target market demographics and trends.
1031 Crowdfunding is a leading real estate investment platform that simplifies the complexities of 1031 exchanges, particularly for those seeking turnkey solutions for acquiring replacement property. We have helped thousands of real estate investors find and invest in their desired investment properties. Our pre-vetted investment options are tailored to match your investment needs, especially if you are looking to invest in real estate without the responsibilities of direct property ownership and management.
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