Better Investment Strategy: Commercial vs Residential Real Estate

commercial vs residential real estate investing
September 6, 2020

Looking to get into real estate investing but don’t know if you should choose commercial or residential properties? Each strategy offers distinct benefits—and of course, different challenges. The right path for you depends on your available liquid capital, investment horizon, risk tolerance, and overall goals. You can even choose to combine both, perhaps starting with one asset class and then adding the other. Here is some vital information you need to know as you make your choice.

Commercial vs Residential Real Estate —What’s the Difference?

There are some technical differences between commercial and residential properties. Single-family homes and rental residences with 1 to 4 units are classified as residential. This includes duplexes, condos, and quadruplexes. Any property with five or more units is classified as commercials, such as office spaces, retail spaces, industrial spaces, hotels, special purpose buildings, and multifamily units. There is also a difference in the tenant type that each kind of property attracts. Commercial real estate or CRE is leased to businesses, whereas residential real estate is leased to individuals and families.

What is Commercial Property?

what is commercial property

And then there is the matter of opportunities that are associated with each kind of asset. In general, commercial real estate offers more comprehensive ranges of a potential investment, as shown by the fact that CRE investment funds are more widely available than residential investment funds. On the other hand, investors looking to play active roles in their property will find more residential real estate opportunities.

What is Residential Property?

what is residential property

Many Benefits of Commercial Real Estate Investing

Suppose you have ever considered putting your money in or diversifying your portfolio with commercial real estate. In that case, you will be happy to know that it offers a wide range of benefits. Here are some of the biggest ones:

  • Higher returns – Commercial properties have the potential to yield higher eat earns than residential properties. That said, they are also riskier. Commercial property returns and cash flow have historically been more attractive. The property index released by the NCREIF (National Council of real estate investment fiduciaries) shows that CRE investments post a yearly return of 12.7% on average—which is much higher compared to the 8.8% annual return posted by the S&P 500 in the last 15 years. This is why CRE properties have always attracted investors who are serious about diversifying their portfolios.
  • Triple net leases – This type of net lease is available uniquely for CRE. In a triple net lease, commercial property owners don’t have to pay any ongoing property expenses such as maintenance and taxes. The lessee handles these costs; all the owner has to worry about is the mortgage. Why? Because many businesses that rent commercial spaces—especially big names like Wal-Mart, Starbucks, and Target—want to maintain a specific field and look that aligns with their brand, so they are willing to manage most maintenance and upkeep costs.
  • Hire potential for increased value – The commercial real estate value largely depends on how much revenue they generate. In contrast, the value of residential properties is mostly influenced by how much comparable properties sell for. If you manage to find a higher-earning tenant/a successful business, you could see a faster increase in the value of your commercial property than you would in any residential rental.
  • Long-term leases – Residential leases typically last anywhere from 6 to 12 months only. On the other hand, commercial leases are much longer, lasting 5 to 10 years on average. This translates to lower vacancy rates and turnover costs and explains why CRE investing appeals to investors who want a reliable positive source of income and don’t want to deal with the hassles of marketing their properties every year. Of course, it’s essential to have legal protections and the right application process in place so that you don’t get stuck with less than desirable tenants for years and years.

Benefits of Investing in Residential Real Estate

While commercial real estate investing advantages are apparent, this doesn’t mean that there is no place for residential properties in a smart investor’s portfolio. You can certainly choose to do both. Below are just some of the many benefits of owning income-generating residential properties:

  • Lower cost of entry – It’s not easy to come up with funding for CRE. An average investor who is just starting will probably have enough for a down payment on a residential asset like a single-family home, but not enough to buy a commercial property. Those who were new to real estate investing may find the process of purchasing commercial properties to be quite overwhelming. That said, many of the most successful property investors start with residential assets and use the cash flow from them to buy commercial real estate later on.
  • Administratively easier – Zoning laws for residential properties are often more lenient. The same cannot be said for CRE; zoning laws are stricter, there’s a lot more red tape to manage, and building permits are generally harder to get. This is why residential properties appeal to newer investors who are not ready for the headaches involved in commercial real estate.
  • A larger pool of renters and buyers – It’s true what they say: people will always need a place to live. This is why residential properties benefit from having more potential buyers and renters. As you know, recent events have forced businesses to adapt to remote work and online marketplaces, so it has become harder to find long-term commercial tenants, but the demand for rental homes remain solid. This is one thing to think about as you make your decision.
  • Better performance in economic crises – While residential real estate is not immune to economic downturns; it’s often not as much affected as commercial investments that rely on business tenants who are often the first to get hit by the costs of uncertain times. Demand for housing is mainly stable; even when the economy is down, people still need homes.

Comparing Commercial and Residential Loans

Traditional lenders like banks distribute residential mortgages to borrowers. Commercial mortgages, on the other hand, are made to a company. It’s recommended for commercial borrowers to sign as representatives of business entities for tax purposes (after all, the property is zoned for commercial uses).

In the eyes of lenders, commercial loans are considered riskier compared to residential mortgages. This is why interest rates for commercial loans are typically higher. The terms are also shorter. That said, more commercial funding is available because of the existence of a secondary market of commercial lenders outside of traditional banks.

There is more paperwork involved in applying for commercial loans. You will need to produce a business plan and, in many cases, show a high credit score. Note, however, that some commercial lenders don’t look at a borrower’s financial circumstances. Instead, they base their decision on the commercial property’s viability and income-generating potential.

There are also crucial differences in the restrictions, conditions, penalties, and terms of commercial and residential loans. Residential properties are typically financed over 30 years, whereas commercial loans range from 5 to 20 years. This is why monthly payments for residential investment properties are smaller. The great thing about commercial loans, though, is that terms and repayment schedules can often be customized based on the borrower’s unique requirements.

Don’t have access to the funding it takes to become a direct owner of a commercial building? Don’t worry—there are opportunities in passive commercial investing. For example, you can invest in CRE companies as a limited partner. This is a good strategy for building a diversified portfolio that includes passive CRE investments.

The Bottom Line

So, should you invest in residential or CRE? That depends on your goals. Are you looking to make a quick profit to start your investing journey? Then flipping a couple of residential properties might make sense. Are you in this for the long haul and want to build a sizable passive income? Then CRE investing offers many attractive benefits.

You also have to think about how much time and involvement you can put into your project. If working on a small scale feels more natural to you, residential investment is a good fit. If you want to earn higher returns and are comfortable taking on more significant risks, look into commercial real estate investing.

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