Should You Invest in Commercial or Residential Real Estate?



Real estate is a popular investment choice due to its historical appreciation, steady income, and exceptional tax benefits. Investors typically focus on either residential or commercial properties.

The COVID-19 pandemic has affected each category of real estate, which affects investors. For example, the stay-at-home orders have increased remote work from home and reduced out-of-home activity, negatively affecting demand for office buildings and physical retail stores. At the same time, interest in residential properties has expanded as residents pursue larger houses and relocate to suburban and rural areas. 

Each category of real estate has unique characteristics, opportunities, and concerns that should be considered before investing.

Residential Real Estate Investing

Residential real estate generally includes single-family homes and one- to four-unit rental residences. Residential properties are typically leased to families and individuals. 

Investors in these properties usually play active roles in their administration and maintenance or contract management companies to care for their properties.

Appeal to Investors

Residential property appeals to investors because of its:

  • Large pool of potential investments: Single-family houses compose the largest number of real estate structures available in various regions and a wide variety of socio-economic groups.
  • Lower barrier to entry: Commercial property investments generally require sophisticated analysis to evaluate, more money, and complicated financing.
  • Straightforward management: Barring large apartment complexes, residential properties involve fewer tenants and less complicated service than commercial property tenants.

Investment Strategies

There are myriad ways to profit from residential property ownership depending on an investor’s interest, capability, and available time. The strategies include:

Flipping

Principals identify houses in need of minor repairs or cosmetic refurbishments selling below market costs. Their objective is to spend as little money as possible – up to $5,000 – and resell the property as quickly as possible (45 to 50 days after purchase). While the profit is limited on each transaction, the gain of multiple transactions adds up fast. Several good books explain the strategy, its nuances, and pitfalls necessary to begin “flipping.” 

Selection and accurate estimates of the improvements are essential. Plenty of people have lost money on fixer-uppers by failing to consider the work, expense, and resale value of the property they are buying.

Buying and Holding

Investors who seek regular income look to lease properties for a steady income in addition to amortizing the underlying mortgage. Owners or their agents are responsible for attracting and keeping suitable tenants, collecting rents, and maintaining the physical property as landlords. Success is dependent on acquitting properties at a cost allowing a positive cash return.

Location is crucial in residential properties. Generally, properties within high-income areas are preferred due to the larger population able to afford higher rents.

Many residential investors buy and hold for specific periods, generally when the tax benefits of accelerated depreciation expire. Some sell after a significant increase in value due to a series of increased rents and cash flows, generating higher market values.

Hacking

Many real estate investors begin by “house hacking,” buying a duplex, triplex, or fourplex. The investor lives in one unit and rents the remaining units to others. In most cases, they seek a rent high enough to cover the mortgage, insurance, and tax payments, thereby reducing their personal shelter costs or earning a profit.

House hacking is not for everyone. Some real estate markets are too expensive to attract renters. Others dislike living close to neighbors, sharing a wall separating the units, a garage, or front and back yards. Nevertheless, hacking is an easy way to get into real estate investment.

Commercial Real Estate Investing

Commercial real estate properties include office, retail, industrial, multifamily (of five units or more), hotel, and special purpose buildings. While residential properties are rented to individuals for months, commercial properties are generally leased to business enterprises for years.

Commercial properties tend to be a higher cost due to scale and financed for shorter periods than residential property. Commercial real estate financing is available from traditional banking and lending sources. In contrast, most residential mortgages are supported by government programs.

Appeal to Investors

Commercial real estate appeals to investors due to its:

  • High financial return: Unlike residential properties whose values are set in comparison with similar properties, commercial property is valued on its income potential. Some sources claim that commercial real estate outperforms the S&P 500.
  • Leverage possibilities: Residential property mortgages are generally limited to specific loan to value (LTV) ratios. Conversely, commercial property can be leveraged as high as the rental income will support, regardless of its cost or comparison with other properties.
  • Tenants and lease terms: Due to its importance to potential customers, commercial tenants tend to maintain their workspace to a higher degree than residential rental tenants. Also, leases tend to be in terms of years, not months like those of residential renters.

Investment Strategies

Commercial real estate owners employ similar strategies as residential investors with subtle differences and more extended holding periods. For example, buyers often buy distressed commercial properties to rehabilitate, refurbish, and rebrand to attract higher rents. However, due to the valuation techniques – comparables versus ROI – commercial property owners necessarily hold a property for longer periods.

Commercial property owners typically employ a “triple net lease” with qualified tenants. Under the terms, the tenant pays the real estate taxes, insurance, and maintenance on the space in addition to a base lease cost.

Comparison of the Property Types

The table defines the similarities and differences between the two types of investment real estate. Tax benefits have not been specified, as each is subject to the same tax treatment.

ResidentialCommercial
Purchase AnalysisMediumHigh
Market Price SourceComparablesRate of Return (ROI)
Acquisition CostsLow to HighHigh
Available FinancingPlentiful, SimpleRestricted, Complex
ROI PotentialMedium to HighHigh
Property Management IntensityLow to MediumHigh
Lease Length6 to 12 months1 to 5 years
Tenant AmenitiesLimitedComplex
Tenant TurnoverHighLow
Tenant ProtectionsHighLow
Lease TermsRestrictedFlexible

Final Thoughts

Each property type comes with a different set of opportunities and requirements. Commercial real estate is generally considered more expensive, more complex, and higher risk but with higher returns than residential property investment. 

Nevertheless, residential real estate investments provide more diversity and less complex management responsibilities than commercial property. The typical residential property investor usually takes a more active role in the property than commercial property investors. Consequently, residential property is the ideal entry-level for those seeking to invest in real estate. Many begin with the purchase of a single rental property and go on to eventually acquire large commercial properties.

Thomas O'Shaughnessy About Thomas O'Shaughnessy

Comments

  1. It really helped when you said that we’ll be able to get a steady income and exceptional tax benefits if we were to invest in real estate. The only asset we own is our house and I think it wouldn’t be so bad to purchase other residential properties. I’ll try to find real estate agents first and check if the local market is going well before making any decision.