Understanding the Differences Between Residential and Commercial Real Estate Investing
April 26, 2018
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What Are The Differences Between Residential and Commercial Real Estate Investing
Real estate has always been a popular choice for investors looking to diversify their portfolio. While successful real estate investing can provide substantial rewards, the barrier to entry and learning curve can feel daunting when compared to purchasing financial securities like stocks and bonds. This problem is compounded by the wide variety of markets, types of properties available, and methods of investment and management. The two most common real estate segments for a new landlord to invest in are residential and commercial. Understanding the advantages, disadvantages, and differences between residential and commercial real estate investing is crucial when deciding what’s right for you. Here are some important distinctions to consider:
Defining Commercial and Residential Real Estate
Broadly, the main difference between residential and commercial real estate is the type of renter you choose to lease. If your tenant will be a family, a young professional, a student, or some other person looking for living space, your property is residential. If your tenant will be a business or individual using the property for some sort of commercial venture, (you guessed it), your property is commercial. Commercial real estate most commonly includes offices and retail space.* Now, there is some added nuance here for larger buildings, but this is only relevant when financing the purchase and for tax classification. We’ll get to that in a moment.
It’s also important to note that the use and purpose of a particular building is often restricted in some manner by local zoning laws. It’s critical that, before making any purchase, you ask the property’s zoning classification. You may have envisioned renting to a tenant that simply is not allowed and having a property re-zoned can be a tedious and costly process. To learn more, start with this article to better understand the different zoning types, then reach out to your local city planning office to understand which classifications and restrictions your community has implemented.
*For the purposes of this article, we will not be dealing with industrial real estate.
Costs of Making a Purchase
When marketing your property, determining management best practices, setting rental prices, making renovations, etc. the above definition of residential and commercial real estate is more than adequate. However, many states technically consider any building containing five or more rented units a commercial property and require that these buildings be purchased using a commercial mortgage. We won’t get into the nitty gritty of a commercial mortgages here, but the bottom-line is that they are a bit more complicated and harder to obtain than their residential counterpart. Any mortgage officer you speak with should know your state’s laws, so be sure to ask them before moving forward.
In contrast to commercial properties, residential properties have much lower starting costs when investing, and mortgages are typically much easier to obtain. Since the risk for residential lending is lower, banks will accept a wider range of credit scores, whereas higher scores will be required for commercial loans. If your credit score isn’t in at least the 700s, it will be extremely challenging to receive a favorable commercial loan. Larger down payments are also necessary due to the nature of commercial projects.
Finally, when applying for a residential mortgage, you can secure significant discounts if you qualify for owner-occupancy status which demands that you live in one unit of your building. You’ll see lower down payments required and likely lower the agreed upon interest rate. And I know what you’re thinking, but by definition, you can only live in one single unit the majority of the time. Can’t double dip for multiple mortgages.
Leasing a Residential Property vs. a Commercial Property
Leasing a residential property is typically easier than leasing a commercial property. Firstly, there are approximately 22 million residential renters in the United States. There are only about 6 million commercial. What’s more, residential demand has continued to outpace supply, so in the residential world, it is certainly a landlord’s market. Marketing channels for reaching prospective residential renters are more mature than commercial, and the leases and applications tend to be simpler. Office or retail units may remain vacant for months, and even after a prospective tenant is found, finalizing the lease may be more complex and time consuming than doing so for a single-family home. Coupled with easier mortgages, it’s clear why the majority of real estate investors choose to make their first purchase residential.
But commercial benefits start with the lease. If you want to learn more, we’ve put together a guide to help you compare different types of commercial leases. Commercial leases may be more complicated to understand, but they have many, significant advantages. For starters, they tend to be for much longer periods of time (typically 5-10 years as opposed to yearly residential leases). As a result, commercial property owners won’t need to fill vacancies as frequently as residential owners (and if you don’t already know, tenant turnover can be costly). Further, it is a common and widely accepted requirement that commercial residents will cover utility and maintenance costs. Landlords can recover even more expenses with a triple-net lease. And if you’re signing a lease for retail purposes and you’re confident in the opportunity in your area, you can include a percent based rent as part of the agreement.
Maintenance & Management
A residential unit is required to have some sort of kitchen and bathroom, although the rules and regulations surrounding this vary by state. Commercial units are not quite as restrictive, but depending on the tenant you hope to acquire, may need substantial additional effort. For example, if you want to house a posh new restaurant in a sub-ground space, you may have to spend quite a bit of money ensuring its properly ventilated for commercial cooking equipment. Those costs can add up quickly. Other commercial renters may simply be looking for an open room, it just depends.
Commercial tenants also generally take on more maintenance responsibility than residential tenants. Thus, these investments can be more hands-off from a day-to-day management perspective. That being said, commercial tenants may still have other requests or larger scale maintenance issues that need to be addressed. Hiring a good property manager is an efficient way to handle these requests quickly and effectively. While residential requests may happen more frequently, commercial issues can cost your tenants in lost revenue (and you depending on your lease structure), so it’s critical that you make sure they don’t linger. Residential investors can hire property managers as well, but if your portfolio is small enough, you can save money by making sure that you are attentive and accessible to your tenants. Investing time, effort and just a bit of money to make sure your property is durable and low-maintenance can pay off tremendously in the long run.
Managing Cash Flow
Commercial real estate is no exception to the rule “the greater the risk, the greater the reward.” The earning potential for commercial properties exceeds that of residential investments. Not only are the returns more significant, but they also occur more consistently due to the longer lease terms. Profit margins for residential properties are already tighter, and high property taxes or significant damages can trim these margins even more. Residential tenants also tend to be a little more unpredictable in terms of whether or not they will pay on time and in full every month. But it’s also important to think about your exit strategy. If you decide that you’d like to sell off a property, or completely liquidate your portfolio, your residential units will almost certainly sell fastest. The same barriers to entry you faced when purchasing a commercial property now exist for any prospective buyer. But if you’re in it for the long-haul, or you’re separated from your investment by an LLC (very common in commercial real estate), commercial offers plenty of cash flow benefits.
The Bottom Line
There are many significant differences between commercial and residential real estate investments. There’s no right or wrong answer for deciding how you want to invest, it all depends on what it is that you hope to gain from your investment and how much risk you can take on. If you’re more motivated by the bottom line and you don’t mind navigating the complexities and challenges that come with it, commercial real estate is where you should invest your time and money. If smaller, hands-on projects are more your style, then investing in a single-family home to improve and rent out might be the best move for you.
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