Investing in real estate can be an intelligent way to diversify an investment portfolio, especially with the stock market’s current behavior. But often, real estate investors aren’t sure whether to invest in commercial real estate or residential real estate.
To help you make the right choice when you decide to buy property, let’s look at the pros and cons of commercial real estate investing versus residential property investing.
Commercial vs. Residential Real Estate
Residential real estate includes single-family homes, condos, co-ops, townhomes, mobile homes, and smaller multifamily property (with four units or less) where people live.
Commercial real estate generally involves places where people work or conduct business, including shopping centers, office buildings, warehouses and distribution centers, and vacant land.
Real estate commercial property can also consist of large residential properties like apartment buildings, student housing, new home subdivisions, and mixed-use developments.
Pros of Commercial Real Estate
There are several distinct advantages to investing in commercial property for sale versus residential property.
Lease terms for commercial property are more extended, generally running between five and ten years or longer. This means that future cash flow is more predictable, and vacancy rates and tenant turnover costs are lower.
Commercial real estate leases are often triple net (NNN), making ownership more hands-off for investors. In addition to paying a base rent, tenants are also responsible for their pro-rata share of building operating expenses, property taxes, and insurance. Passing these expenses through to the tenant allows CRE investors to reduce their risk of ownership.
Commercial property can also generate a higher return on investment (ROI) than houses or small multifamily property. It is easier to add value to commercial real estate by incrementally increasing cash flow by charging extra for features and services such as covered parking in an office building or individually metering each suite’s water use in retail property.
Drawbacks to Commercial Real Estate
Although there are various benefits to investing in commercial real estate, there are also some drawbacks that investors should keep in mind.
Longer lease terms in commercial real estate can be good and bad. For example, if a property owner wants an existing tenant to leave to re-lease the space to a better occupant willing to pay more rent, breaking the lease and buying the tenant out can be very difficult to do.
Property management of commercial real estate is also more difficult and complex. Corporate and business tenants are more professional than residential renters, but they are also more demanding. Commercial property managers have experience with the specific property type – such as office, retail, or industrial – and each tenant’s unique requirements.
Risks can also be greater with commercial real estate. In addition to the business tenant and its employees, commercial properties also have public visitors. Accidents can occur in parking lots, people can slip and fall on ice, and vandalism or trespassing can happen overnight. While the same things can occur with residential property, a commercial property with more foot traffic, tenants, and valuables increases the problem’s odds.
Pros of Residential Real Estate
There are several reasons why many beginning investors choose to start small by investing in residential real estate.
First, everybody needs a place to live — that’s why houses and small multifamily buildings are almost everywhere. It’s generally easy to find residential property for sale, and owning and operating a house is easier for first-time or low-maintenance investors.
Residential real estate investors also have multiple exit strategies when the time comes to sell. For example, they can sell to the current tenant, sell the house to an owner-occupant, or another investor.
Rental homes and residential property can also perform better in both good and bad economic times. Residential leases are usually for one year or less, and it is easier for landlords to lower or raise rents based on current economic conditions. The potential pool of renters is also larger with residential property, reducing the risk of vacant property for an extended period.
Drawbacks to Residential Real Estate
At first glance, residential real estate may seem less risky than commercial property. However, there are several drawbacks to investing in residential property of which to be aware.
Because residential leases are for shorter terms, vacancy rates and turnover costs can be higher than expected. Tenants who rent for a short time may be less inclined to take care of their place and move more frequently. And when a renter vacates a single-family home, the vacancy rate is 100% until the house is re-rented.
Many cities and states have rent control laws that significantly impact the returns on residential rental property. Local and state ordinances limit how much landlords can raise residential rates each year (rent control laws) and how large a deposit a landlord can collect. Over the past year, governments nationwide have also prohibited residential evictions due to the coronavirus, even if the tenant cannot pay the rent — though the Supreme Court recently struck down the latest eviction moratorium extension by the CDC.
Adding value to residential real estate is also more difficult. That’s because there are only so many things a residential landlord can do to generate extra revenue. On the other hand, commercial tenants are more willing to pay for additional services for their employees and customers.
Financing Commercial vs. Residential Property
The cost of entry to buy and finance a residential property is much lower than with commercial. Residential investors benefit from government-backed loan programs with low down payments and historically low interest rates. It is also much easier to find a lender willing to finance a residential purchase because funding of a commercial property is more specialized.
However, the higher cost and complexity of financing commercial real estate also creates opportunities. For example, because down payments on commercial loans are higher, less competition is found among experienced CRE investors.
Also, unlike buying a house, terms and conditions on a commercial loan can be customized to meet the investor and the lender’s unique needs.
By timing mortgage payments to match a property’s cash flow, commercial real estate investors can more easily develop projects such as repositioning a shopping center into a last-mile distribution space or renovating a hotel into a large apartment building.
What to Know Before Investing in Commercial Real Estate
Another big difference between commercial and residential real estate is analyzing the financial performance of the investment. Both asset classes use simple calculations such as capitalization rate, cash on cash return, and return on investment (ROI).
However, there are a variety of metrics investors should use to evaluate commercial real estate for sale.
For example, CRE investors should have an exit strategy before buying because there are fewer options for selling a commercial property than for a house. Commercial property can take a long time to sell, and buyers are often more sophisticated than the average homebuyer or residential investor.
Many of the benefits of investing in commercial real estate also makes buying commercial property more time-consuming. Investors should take the time to analyze items such as tenant credit quality and rent payment history and review the profit and loss statements for the last several years. Potential owners should also conduct due diligence to confirm whether tenant improvements (TIs) were completed according to zoning codes, verify that parking ratios are sufficient for current and future tenant mixes, and other items on their checklist.
Which is the Better Choice?
There’s no clear winner in the commercial versus residential real estate investing debate. There are definite pros and cons to each, and the right choice for one investor could be the wrong decision for another. For investors buying and holding over the long term, higher returns and passive income streams from commercial real estate can create desirable benefits that are difficult to find with rental homes.