Which type of real estate presents a better investment, residential or commercial property? While commercial and residential property investments exhibit distinct differences, they also share certain similarities. These shared characteristics can complicate the decision-making process when it comes to selecting 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.
Understanding Residential Real Estate Investing
In some cases, you may want to invest in residential real estate. Before you make your decision, you may want to understand more about this type of investment and consider some pros and cons.
What Is Residential Real Estate Investing?
A residential real estate property is a residence or complex with one to four units. Residential properties include:
- Duplexes
- Triplexes
- Quadruplexes/quadplexes
- Apartments
- Townhomes
- Cooperatives
- Condominiums
- Single-family homes
- Individual mobile homes
Residential real estate is used strictly for living purposes, as commercial use of a residential property would violate local zoning ordinances.
This investment strategy entails identifying prospective tenants interested in occupying the properties, who are often individual residents or families. It is important for landlords to conduct a comprehensive screening of potential tenants, evaluating their income, credit history, and previous tenancy records to ensure they are likely to demonstrate responsibility in property upkeep. Following the signing of the lease, it is customary for the tenant to pay a monthly rental amount to the property owner.
Tenant turnover decreases when marketing is aimed at longer-term renters, reducing stress for landlords. In many cases, a long-term renter is 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 could also provide real estate investors with a more predictable 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. It can be easier to understand what is expected from the relationship between landlord and tenant in a residential investment from your firsthand experience. You can invest in residential real estate with little or no experience and much less money due to the availability of residential properties.
- 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 consistent since there will always be someone who needs somewhere to live. This large rental pool can also locate rental properties easily on the internet, allowing you to find a tenant quickly.
- 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.
- Higher vacancy risk: The high tenant turnover potential can lead to a high risk of vacancy. The availability of residential properties may make it more difficult for your property to stand out from comparable options.
- 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 living situation, 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 lack of maintenance 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.
Understanding Commercial Real Estate Investing
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:
- Retail buildings such as malls, restaurants, and banks
- Industrial buildings such as manufacturing facilities and warehouses
- Hospitality facilities such as hotels
- Office buildings with one or more tenants
- Multifamily buildings such as apartment complexes
- Special-purpose buildings intended for a specific use, such as storage facilities or car washes
- Senior housing such as independent and assisted living or memory care facilities
- Vacant land with potential for commercial 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 investing in commercial real estate, such as:
- Appreciation potential: With a commercial property, investors can potentially increase the property’s value with minimal investment. Commercial properties can be 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.
- Respect for the property: If you want tenants who take great care of your property, you may be better off with commercial real estate investing. Corporations and businesses are usually the tenants of commercial properties, which leads to tenants being more inclined to maintain and respect the property, as the workplace is a reflection of their company.
- Longer leases: Commercial leases tend to last several years. Since relocating a business is difficult logistically, most companies want to maintain one location for longer than tenants with residential leases. For commercial real estate investors, these long leases generate a reliable cash flow, low tenant turnover, and decreased vacancy rates.
- More predictable 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. Commercial properties are typically bigger than residential properties, meaning you can have more tenants or income.
- 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.
- Potentially 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. Since commercial property options are fewer, finding one can be more challenging.
- More competition among investors: Commercial real estate investors may face competition from crowdfunding opportunities, experienced investors, and Real Estate Investment Trusts (REITs). This competition can make it more difficult to secure your desired commercial property.
- 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.
- High risk of vacancy: While commercial properties often have a lower tenant turnover than residential, their vacancy periods may be longer. The logistics of relocating a business and renovating the space discourage most businesses from moving to a new storefront. 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.
Risk
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. However, the costs of operating a commercial property tend to be higher for investors.
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.
Cost
The costs of commercial and residential properties are different, even between similar-size properties. Regarding the building facilities, residential real estate investors may face high costs for labor, equipment, and overhead, commercial real estate is generally more costly due to factors such as:
- High number of workers, project managers, and contractors required for building or renovation projects
- Wages for these employees
- Use of specialized equipment
- Complex scheduling
However, commercial property projects are generally completed faster than residential ones. Whereas changes are not common in commercial projects, they are more frequent in residential construction, resulting in project delays.
Return on Investment
Finally, you may also want to consider what level of return on investment (ROI) you are expecting. In real estate investing, ROI can vary by the type of property, location, property management costs, vacancy rate, cash-on-cash returns, and cap rate. No average ROI applies to all rental properties, so you may want to do your research on the properties in the area in which you are considering buying.
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