Is it better to invest in residential or commercial property? Though there are some differences between commercial vs. residential property investments, they have some similarities as well. These common characteristics can make it confusing to determine which property type is the right investment for you.
Each investment property has different levels of risk, income, return and capital needed. These factors can influence whether residential properties or commercial properties are the right investment options for you. If you are an investor looking to learn more about the differences between investing in commercial vs. residential real estate, we have developed this guide for you.
Residential Real Estate
In some cases, you may want to invest in residential real estate. Before you make your decision, you may want to consider some pros and cons.
What Is Residential Real Estate Investing?
A residential real estate property can have between one and four units. Residential properties include:
- Single-family homes
- Individual mobile homes
This investment option involves finding tenants who want to live in the properties. Landlords should screen tenants and review a potential tenant's income, credit and previous rental history to make sure this person will be a responsible tenant and take care of the property they live in. After a tenant moves into a house or apartment, in most cases, they will pay rent each month to the owner.
Tenant turnover decreases when marketing is aimed at longer-term renters, reducing stress for landlords. In many cases, a long-term renter tends to be more likely to treat a rental like their own home, which means they may take better care of the property and maintain it. Long-term renters also provide real estate investors a steady stream of income.
Pros of Residential Real Estate Investing
There are several pros of residential real estate investing, such as:
- Lower barriers to entry: Typically, it is easier to get into residential real estate investing, and many of us are familiar with life as a renter, so we understand what is expected from the relationship between landlord and tenant. You can invest in residential real estate with little or no experience and much less money.
- Easier property management: With a residential property, property management tends to be easier than with a commercial property. Managing a single tenant or household can be much easier than managing an entire apartment complex with hundreds of tenants. Depending on how many properties you own, you may not need to hire a property manager, especially if you can handle all maintenance, repairs and rent collection yourself. However, you may want to hire a property manager if you own several residential properties or don't want to perform all these property management tasks yourself.
- Tax benefits: Regardless of what type of property you own, you can reap tax benefits when you invest in real estate. If you own property with tenants, you can deduct expenses related to home improvements, repairs, mortgage interest, rental income, depreciation and property management costs.
- Steady demand: Across many parts of the nation, the demand for residential rentals is steady. Everyone needs somewhere to live, and since many millennials are choosing to rent for a greater length of time before purchasing homes, you may be able to find a renter faster.
- Easier to analyze: With residential real estate, you can make money through cash flow, equity and appreciation. You can more easily analyze the metrics involved via common ratios, such as return on investment, capitalization or cap rate and cash-on-cash return.
Cons of Residential Real Estate Investing
There are also some disadvantages to choosing to invest in residential real estate, including:
- Higher tenant turnover: Leases for residential properties can be quite short, ranging anywhere from a month-to-month contract to a two-year contract. In residential leases, tenants are usually families, individuals, friends and roommates.
- Emotional element: Since a residential property is someone's home, there is an emotional element to residential real estate investing, whereas commercial real estate investing is usually more transactional in nature. So if you do not want to be responsible for someone else's home, you may not want to invest in residential real estate.
- Short-term tenants may not take care of the property: If you are willing to rent to tenants for shorter terms, they may be less inclined to take care of the property. This could mean you have a lot of cleanup to do and repairs to make after your tenant moves out. However, if you rent for longer terms, you may end up with tenants who take better care of the property.
Commercial Real Estate Investment
In some cases, you may want to invest in commercial real estate. Before you decide whether commercial real estate investing is right for you, you may want to consider some pros and cons.
What Is Commercial Real Estate Investing?
A commercial real estate property is a property that has five or more units or a property used for business purposes. A few examples of commercial real estate properties include:
- Office buildings
- Multifamily buildings
- Apartment complexes
- Manufacturing facilities
- Vacant land with potential for development
Corporations and businesses often lease commercial properties, and commercial lease agreements are used when securing tenants for these properties. Lease agreements are often more complicated at the commercial level and may include triple net leases, absolute net leases, full-service leases, and modified gross net leases.
Pros of Commercial Real Estate Investing
There are several pros of commercial real estate investing, such as:
- Easier to increase value: With a commercial property, it can be easier to increase the property's value. A residential property's value is based on the average value of other comparable properties in the area. Commercial properties are valued more precisely based on local comparable properties and the amount of revenue the property generates, which means even an inexpensive improvement may significantly impact the property's resale value.
- Lower tenant turnover: If you want lower tenant turnover, you may be better off with commercial real estate investing. Corporations and businesses are usually the tenants of commercial properties, and leases tend to last several years. This leads to tenants being more inclined to maintain and respect the property, as the workplace is a reflection of their company.
- More consistent cash flow: Since you will likely deal with lower turnover and less frequent vacancies, your cash flow from a commercial property could be more reliable than the cash flow from a residential property.
- Escalation clause: Since leases for commercial properties tend to be longer, you can also include an escalation clause in the lease. This clause requires your tenant to pay a portion of the building's increase in expenses, which may include real estate taxes and operating expenses. The tenant will pay these costs along with the base rental payment.
- Tax benefits: Similar to investing in residential properties, you may be able to enjoy some tax benefits when you invest in commercial properties. A commercial property owner can deduct rental income, repair costs, mortgage interest, depreciation and property management costs, along with other expenses associated with a commercial property.
- Fewer expenses: If you are a landlord of a commercial property, in some cases, your tenant will cover your costs for maintenance, insurance and taxes. Retail, office and industrial properties often use a lease known as a triple net lease, which states the property owner isn't responsible for paying expenses associated with the property, including utilities, insurance and taxes. Additionally, an absolute net lease will place all financial responsibility on the tenant, including for the building's structure.
Cons of Commercial Real Estate Investing
Some disadvantages to choosing to invest in commercial real estate, include:
- Greater barriers to entry: Investing in commercial property is generally more complicated than investing in residential property and requires more research to identify and evaluate properties. Buying a commercial property requires a much greater financial investment than a single-family home, and the associated risks are higher, as there is more money invested in a hard asset that you cannot easily liquidate.
- Challenging property management: Managing a commercial property yourself tends to be more challenging than managing a residential property. Managing maintenance and repair requests and collecting rent can be much more complicated and demanding at the commercial level. Offices and industrial spaces come with a greater number of units and more complex repairs. To avoid frequent tenant turnover and keep your tenants happy, you may want to hire a property manager.
- Riskier during an economic downturn: During an economic downturn, retailers tend to be the first to suffer a hard hit. Even during favorable economic conditions, small businesses have a high rate of failure, so you may not be able to predict if your tenants will be in business for the duration of the lease.
- Complex zoning laws: At the commercial level, zoning laws are often more involved, as there are several categories of commercial zoning. Regulations depend on the property's business use and the number of patrons. For instance, ordinances may mandate a minimum number of parking spaces or the number of similar businesses that can be located in the same district. Vacant land that could be developed into a commercial building can also be zoned as commercial property.
- Less competition: There is less competition for businesses renting commercial properties, which drives down rental prices. Retailers face competition from big box stores, and online retailers can deliver similar products more conveniently and affordably, so there are empty commercial spaces across the country and not enough tenants to occupy them. As a result, it can take months to rent a commercial property after a vacancy.
- More complicated to analyze: With commercial real estate investment, you need to evaluate more metrics. This type of investing is more similar to owning a small business than residential real estate investing, and making money is related to increasing the net operating income.
What to Consider When Choosing Between Commercial vs. Residential Real Estate Investment
If you are uncertain whether you should invest in commercial or residential property, consider the following factors to help you make your decision.
Many real estate investors are looking for a passive income source. If you are looking to purchase a property that requires little or no ongoing effort while still yielding income, you may want to consider commercial real estate investing.
This type of investment property tends to be a more passive source of income, as a residential property may require you to interact with the tenant regularly for rent payment and to perform maintenance and repairs on the property. If you deal with high tenant turnover for your residential property, this will also require more effort on your part to screen prospective tenants and prepare the property for a new tenant.
While commercial real estate tends to bring more risk, greater risk can mean greater returns. In comparison to residential properties, appreciation and cash flow from commercial real estate tend to be more attractive. This is because businesses sign long-term leases and can afford higher rent payments than individuals.
Regardless of whether you are renting out a residential or commercial property, it is essential to review each prospective tenant's background, credit, income and prior rental history to ensure they will properly maintain the property and make their rental payments on time.
Return on Investment (ROI)
Finally, you may also want to consider what level of return on investment you are expecting. In residential real estate investing, ROI can vary by the type of property, location, property management costs and vacancy rate. No average ROI applies to all residential rental properties, so you may want to do your research on the properties in the area in which you are considering buying.
In commercial real estate investing, real estate investors compare prospective properties by examining cash-on-cash returns and the cap rate. Similar to residential properties, ROI for commercial properties can vary based on property type and location.
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