The Short Version
- While there are pros and cons to commercial and residential real estate investing, residential can be a better choice for the average investor.
- Good commercial spaces may be expensive and hard to come by, but the property value increases if you have a successful tenant.
- Residential spaces weather economic downturns better and are more accessible to the average investor.
2 benefits (and 1 drawback) of commercial real estate investing
Commercial real estate investing has become a popular way to make money, but there are both benefits and drawbacks that you should be aware of before getting started. Here are a few key points to keep in mind.
Benefit 1: It's easier to increase the value of a commercial property
The market value of a residential property is determined by the average value of comparable properties in the neighborhood. This is based primarily on features such as the number of bedrooms and bathrooms. So, in general, a two-bed, two-bath property with top-of-the-line appliances has about the same value as another two-bed, two-bath house on the same block with a basic kitchen.
Commercial real estate is valued with a different approach. Sure, local comps are considered. But the market value is almost entirely based on the revenue the property generates. So a strategic, inexpensive improvement can hugely impact a property's value if it increases the revenue generated by the commercial property.
If you're interested in investing in commercial real estate, you can easily do so through a crowdfunding platform like Fundrise. You can invest in various commercial real estate projects through REITs for as little as $10.
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Benefit 2: Enjoy longer lease terms with commercial properties
Commercial leases are much longer than residential leases. Residential leases often run for 12 months. A commercial lease is typically at least three years. Leases for five and ten years are not uncommon.
The benefits of a longer lease are:
- More assurance of reliable cash flow
- Lower vacancy rates
- Lower turnover costs
Of course, there's a downside to longer lease terms. If you're unhappy with a tenant, it's easier not to renew a short-term lease (and make them leave) than to break a long-term lease.
Drawback: Commercial deals are more complicated to analyze
You can make money with residential real estate investing in three ways: cash flow, appreciation and equity buildup through paying down a loan. With residential real estate, you must understand common ratios like return on investment, cash-on-cash return and capitalization (cap) rate. With commercial properties, you need to understand and evaluate these, plus other metrics.
Commercial real estate investing is more like owning a small business. The most important thing is to increase your net operating income. In addition to other acquisition and valuation ratios, you need to get details like maintenance records, expenses and rental history. All of which are often not found in a listing. And then, there are the operational ratios and analysis. You need to look at the last 12 months of profit-and-loss statements.
3 benefits of residential real estate investing
If you're looking to buy your first investment property, there are multiple reasons why you may want to start with residential real estate. Here are three benefits of this type of investment.
Residential properties perform more consistently in economic downturns
Residential properties weather economic downturns much better than commercial retail space does. When there's a market downturn, retailers can be hit hard.
Even in good economic conditions, small business owners have a high failure rate. So, though you have longer leases with commercial properties, there's no guarantee that your retail tenant will remain in business. This could be even more of a concern right when many economists are predicting a recession by 2023.
People need a place to live no matter what the economy is doing. And when there's a downturn, residential property owners don't suffer as much or as quickly. Renters prioritize paying rent to ensure they have a place to call home.
Residential real estate investing has lower barriers to entry
It's easier to start with residential real estate investing because it's simpler to understand. Most of us have been renters at some point in our lives. We understand the landlord/tenant relationship. We're familiar with what's expected on both sides of the table.
It takes minimal experience — and a lot less money — to invest in residential real estate. In fact, you can even get cash in the equity in your property from investors like Hometap. And if you need money for renovations or repairs, you can use Monevo to compare your loan options.
Commercial deals are much more complicated and require much more research to find and evaluate. It takes far more money to purchase commercial real estate than a single-family home. And the risks are higher. For one thing, there's a lot more money on the line. And all that money is invested in a hard asset that can't be moved or readily liquidated.
The buyer pool is larger for residential properties
Compared to other sectors, the retail sales sector of the U.S. economy has not been performing well. Mom and pop stores face stiff competition from mammoth retailers like Amazon, Walmart, and Target. And even in niche categories, online retailers can often deliver the exact same products cheaper and more conveniently.
COVID-19 emptied many commercial spaces throughout the country and some of the may never be refilled. This drives down the rental prices. And it often takes an average of six months to rent a commercial space. This is a factor that increases the cost of vacancies.
On the other hand, residential rentals have a steady demand in most of the country. Everyone needs a place to live. As a whole, Millennials rented longer before buying homes and many expect that trend to continue with Gen Z.
It takes less time to find a renter. It often takes just 30 to 45 days in most markets. I recently rented one of my properties with no vacancy time. One tenant left on June 30, and a new one moved in on July 1.
Plus, it can be easier to find a real estate agent to help you find a good deal. Consider using a service like HomeLight if you decide you want to buy a residential property. HomeLight matches you with successful real estate agents in your area, and it's free to use, as the agent pays for HomeLight's fees.
If you'd like for the local of your rental property to be different than where you live, you may want to check out Roofstock. Roofstock is an online marketplace for tenant-occupied investment properties that connects buyers and sellers all across the United States.
Commercial vs. residential real estate investing: Which is easier to finance?
On this point, I've read conflicting information from seasoned investors. One side says it's easier to secure large amounts of capital for a commercial deal than to generate lower amounts for residential properties.
But the other side says that many banks are reluctant to lend to commercial retail spaces because they are seen as a higher risk due to the online retailer effect.
One key factor that affects financing is the location. Some metropolitan areas are booming, but others are in the depths of an economic rut. Where I live, it seems that the banks are not interested in writing a loan unless there are tenants with long leases already in place. So, there are not a lot of good deals available. If an owner already has a property with solid tenants, why would they sell?
Commercial vs. residential real estate investing: Which delivers a better return on investment?
Investors and experts disagree on the numbers regarding return on investment for commercial vs. residential. Residential investors in my area aim for a cash-on-cash return of 8–12% after all expenses. Investors in some parts of the country wouldn't even consider a rental property if it didn't promise a return of at least 15%.
The return on investment also varies from one kind of property to another. No average return applies to all rental properties. It depends on location, property type, vacancy rate, property management costs and other factors.
Furthermore, while home prices are high across the board, many experts predict that it's not a bubble and these increases are here to stay. That means if you bought a few years ago, you're looking at significant returns on that investment.
For commercial properties, investors compare properties by looking primarily at cap rate and cash-on-cash returns. Again, there's a lot of variation based on location and type of property, but the consensus seems to be that commercial investors aim for a cap rate of 8–15% and a cash-on-cash return of 10%.
The bottom line: I'm sticking with residential… for now
It's crucial to keep your risk to a minimum, whether you're investing in residential or commercial.
Commercial real estate requires a larger cash outlay. And you're putting all your eggs in one basket if you can afford only one commercial property. With residential properties, you can spread out your risk and diversify across multiple types of properties located in different areas.
I've learned that investors can make — and lose — a lot of money in every niche of real estate. Those who do well pick a niche, become an expert and execute a sound strategy within that niche. Rookies lose money when jumping in because they saw someone else make money.
At this point in my investing career, I will stick with residential. I have experience in that niche. Also, I believe it's riskier to put all my funds into one commercial property than to spread my risk across many residential properties. It's not as big a financial setback if you miss your mark with one single-family home. It's much more costly to miss the mark with a commercial building.