Deciding between commercial vs. residential real estate investing is not a decision that can be made overnight. Each strategy offers its own set of benefits as well as its own set of challenges. An investor’s path will depend on their goals, risk tolerance, liquid capital, and time. Review the following benefits before making your final choice.
What Is The Difference Between A Residential And Commercial Property?
The technical difference between a residential and commercial property is as follows: Residential real estate is all single-family homes and one to four-unit rental residences. In contrast, commercial property is anything with five or more units. Condos, duplexes, and quadruplexes make up residential real estate, while office, retail, industrial, multifamily (of five units or more), hotel, and special purpose buildings are considered commercial real estate.
Another stark difference between commercial and residential properties is in the type of tenant each building attracts. Residential properties are typically leased to families and individuals, while commercial properties are leased to businesses.
Lastly, each property type comes with a different set of opportunities. Commercial real estate tends to award investors a much wider range of potential investment. For example, there are more commercial property investment funds than residential ones. On the other hand, residential real estate investing tends to give investors a more active role in the property.
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Benefits Of Commercial Real Estate Investing
Smart investors know that it is of utmost importance to evaluate all the pros and cons before making a final investment decision. However, these benefits of commercial real estate investing are undeniable.
Higher Returns: You’ve heard the saying, ”with greater risk comes greater reward,” which is quite poignantly the case with commercial properties and higher returns. Compared to the returns on residential properties, commercial property cash flow and returns are far more attractive. According to the National Council of Real Estate Investment Fiduciaries (NCREIF), Property Index, commercial real estate investments have an annual average return of 12.7 percent compared to the S&P 500, with an average annual return of 8.8 percent over the past 15 years. More space equals more tenants, which equals more money in your pocket. Not bad for an investor looking to diversify their portfolio.
Qualified Tenants: It can sometimes be difficult for investors looking to rent out their single-family property (or small multi-unit property) to find tenants who are qualified and who will keep the property up to snuff. On the other hand, commercial tenants tend to be businesses, corporations, or something of the like. Because a larger company backs them, they are typically more likely to respect the property and its rules. While this is not always the case, qualified tenants will make any property owner’s life easier.
Triple Net Leases: While triple net leases vary from case to case, they are extremely valuable for commercial real estate investors. The property owner does not have to pay any property expenses with a triple net lease. The lessee handles all property expenses directly, including real estate taxes, so the property owner has to pay the mortgage. Big companies (think Starbucks, Target, Walmart, etc.) will typically sign this type of lease to maintain a look and feel in line with their branding. So they manage those costs while the investor pays practically nothing in maintenance costs. Talk about a win-win. Investors can adopt various net leases; however, a triple net lease benefits commercial properties alone.
Longer Lease Terms: Commercial leases tend to be much longer when compared to residential properties, which typically range from six to 12 months. It is not uncommon for commercial properties to lease for anywhere from five to 10 years. For investors, this means lower turnover costs and vacancy rates. The long lease terms signal reliable, positive cash flow for those worried about marketing a property from year to year. Commercial investors can end up with less than desirable tenants for extended periods of time. Still, with the right application process and legal protections, investors can avoid any long-term issues.
Easier To Increase Value: One of the biggest differences in residential and commercial real estate is how property values are determined. While comparable properties largely influence residential real estate, commercial real estate is directly impacted by its revenue. Simply put, the amount of cash flow a commercial property is earning, the higher the property value will be. With the right tenants, investors could see an increase in value at a much faster rate than residential housing.
Benefits Of Residential Real Estate Investing
Both commercial and residential real estate investing have positives and negatives. To decide which strategy is right for you, it’s important to review the benefits and determine which ones align more with you and your business’s core values.
Cost Of Entry: While it is possible to obtain commercial real estate loans even as a newbie investor, the cost of investing in residential real estate is most certainly less than commercial real estate — at least to start. The average person may not have enough savings for a sizable down payment on a commercial property, while they are much more likely to have enough saved for a single-family home. If the thought of a commercial property sounds too overwhelming for a new investor, think of it this way: Once an investor has purchased several cash flow producing residential properties, they will likely have the capital and necessary experience to invest in a commercial building.
Decreased Tenant Turnover: For residential real estate investors, especially if their focus is on single-family homes, tenant turnover is not something dealt with often. Businesses change and grow, and those are usually the tenants that make up commercial properties. With that kind of volatility, it can be difficult to keep tenants for long periods of time. This means more work has to go into finding tenants regularly instead of once in a blue moon. In fact, if you market and screen tenants correctly as a residential real estate investor, you can find individuals who are committed to being long-term renters. If you focus on acquiring only long-term tenants, you can be more confident that they will treat the home as if it’s their own.
More Lenient Zoning Laws: With commercial investing comes far more red tape to deal with as the property owner. Zoning laws are more strict, building permits are harder to come by, etc. With residential real estate, rules and regulations are more lenient and more small scale.
Larger Buyer And Renter Pool: Think about it: everyone needs a place to live, right? Residential real estate benefits from having a large pool of potential tenants and buyers compared to commercial real estate – which relies on businesses. As companies acclimate to online marketplaces and remote work opportunities, investors may find it harder to attract commercial tenants in some markets. The high demand for residential real estate makes this a particularly attractive opportunity for investors, no matter the market.
Performs Better In Economic Crisis: Businesses are often the first to experience the costs of an economic downturn, which can affect commercial investors in a few ways. First, commercial property owners hoping to attract tenants while the economy is in decline may find marketing the property to be particularly challenging. Residential real estate is by no means immune to these challenges; however, as a whole, residential property owners will benefit from the fact that housing is always in demand (despite the state of the economy). There is also no guarantee a company will stay in business for the duration of a commercial lease. This can present a unique challenge for commercial investors counting on long-term tenants.
Commercial Loans Vs Residential Loans
Traditional residential loans, or residential mortgages, are typically distributed by banks to borrowers. Unlike residential mortgages typically between banks and individual buyers, a commercial mortgage is made to a company. It is also usually in the borrowers’ best interest to sign as a representative of a business entity for tax purposes — since the property is zoned for business uses.
Also, commercial loans are riskier (in the eyes of lenders) than residential loans. This makes a commercial loan’s interest rates higher and terms shorter. Why? Because there is a whole secondary market for commercial lenders that is separate from traditional banking institutions. Imani Francies, investing expert with USInsuranceAgents, states that “for commercial loans, the term might be anywhere from five to twenty years, with an amortization time that is frequently more than the term of the loan. Commercial lenders can also tailor the repayment plan to meet the individual needs of each borrower”.
To qualify for a commercial loan, investors are required to have a business plan and a solid credit score — for the most part. Commercial lenders are more concerned with the property’s projected cash flow than residential lenders are. They will want to know who will pay utilities, what type of maintenance will be required, and more before approving the loan.
Finally, the terms, conditions, restrictions, and penalties vary greatly between commercial and residential loans. Homeowners usually finance their properties over lengthy periods of time. — most commonly with 30-year fixed-rate mortgages. Although residential buyers have many other loan options available, this time frame is ideal due to a longer amortization period that creates smaller monthly payments. Residential loans are typically amortized over the loan’s life, so the loan is fully repaid at the end of the term. Unlike residential loans, terms for commercial loans typically range from five to 20 years, and the amortization period is often longer than the loan term. Commercial lenders are also able to customize the loan repayment schedule to each borrower’s specific requirements.
Commercial Vs. Residential Electricity Rates
The quality of the energy consumed in commercial and residential properties is the same. However, because commercial property owners tend to buy electricity in bulk, electric companies often offer discounts and different tariffs. These commercial electricity tariffs often allow business owners to purchase electricity at a cheaper rate. The volume they must consume ensures that electricity companies will recuperate ample funds for their energy.
What Is Passive Commercial Investing?
Passive commercial real estate investing allows individuals to invest as a limited partner with commercial real estate companies. While an investor can become a direct owner of a commercial building, the amount of capital required to do so typically makes it difficult to enter the sphere. Rehabbing, prehabbing, and wholesaling commercial and residential properties is a great exit strategy for those looking to make a living in real estate. However, investors seeking a more diversified and balanced approach to real estate investing may be better off rethinking these strategies and, instead, opting to build a portfolio of passive commercial real estate investments.
Commercial vs. Residential Building Costs
The costs of commercial vs. residential real estate are usually widely different, even if the properties are similar in size. The cost differences include materials, compliance standards, overhead, labor, and equipment.
For commercial properties, the amount and quality of workers and the use of specialized equipment strictly for commercial construction can heavily increase costs compared to residential real estate. On top of that, there are usually many more people involved in a commercial project, and those people all need to be paid. Costs really start to add up from the project manager to the general contractor to all of the subcontractors underneath them needed to complete the project. Scheduling all of the different pieces of a commercial project can also be a challenge due to so many moving parts, and rescheduling often comes with a cost.
On the flip side, all of these costs usually end up resulting in a faster completion time than that of a residential project. Homeowners also tend to change their mind often during the construction process, resulting in delays and schedule changes. These changes aren’t as common in commercial projects as it is much more difficult and expensive to make changes on this larger scale. Residential real estate may have significantly high costs for overhead, labor, and equipment. However, building residential real estate rarely compares to the cost of commercial as it is on a much smaller scale.
Commercial Vs. Residential Real Estate Agents
There are many similarities between commercial and residential real estate agents. Still, it is important to understand the key differences to determine which path would be the right fit for you.
Education & Training: Real estate agents will be required to complete training and education to obtain a real estate license regardless of whether they are involved in commercial or residential real estate. However, commercial real estate agents should have a college degree in either business or finance to better understand the financial concepts of the deals they will encounter and undergo more mentorship training before entering the field.
Property Types: The clear distinction between these two types of real estate agents is the type of property they work with. Residential real estate agents only work with residential property, whereas commercial agents can encounter property used for multiple purposes. Therefore, commercial property agents must have the knowledge required to distinguish the proper processes and legalities of both residential and commercial property deals.
Earnings: Commercial property tends to present a higher earning potential than residential real estate. Although it is easier to get a residential property off the market, commercial agents can make a higher commission from the properties they sell.
Clients: Residential properties are easier to sell due to economic factors that can affect the commercial real estate market in different ways. Residential real estate agents have an easier time searching for tenants to occupy their properties, while commercial real estate clients are less abundant.
Worklife: The work-life of a commercial real estate agent vs. residential agents vary in work schedules and responsibilities. Residential agents can expect to be available to work at unconventional work times, including evenings and weekends. On the other hand, commercial real estate agents typically stick to the 9 to 5 workday. However, commercial agents take on a heavier workload, which will involve researching and reporting on market and economic trends to ensure their more intricate deals.
Choosing Between Commercial And Residential Real Estate
Choosing between a commercial vs. residential investment property is no easy feat to tackle, especially because both come with their own set of benefits and drawbacks. Both will diversify your portfolio, both come with significant tax benefits, and both will bring you one step closer to achieving your financial freedom…So how is an investor to choose?
The answer to that question ultimately depends on what they want to gain by investing in real estate. Investors should take some time to think about their short and long-term goals. If they are looking to make a quick buck to start, rehabbing or wholesaling a residential property might be the way to go. On the other hand, if they are in it for the long haul and looking to achieve passive income, commercial properties offer attractive benefits.
Overall, there are numerous considerations to make when choosing between commercial vs. residential investments. If you want to earn the most returns, you might want to consider investing in commercial real estate. On the other hand, residential properties may be more appealing if you’re more comfortable working on a small scale. Thinking about how much time you’re willing to devote to your project and your risk tolerance can make it easier to decide where to invest your money. Keep your goals in mind as you decide and remember, there is nothing saying you can’t choose the other type down the line.
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