While the commercial and residential investment sectors share some common characteristics, there are several important distinctions between them as well. Specifically, an investor should expect significant differences between the levels of risk, return, income, and capital needed in residential vs. commercial real estate.
To start, let's first define residential real estate and commercial real estate and then dive into what to expect when investing in these two asset classes, including specifics on how to obtain loan approval.
What is residential real estate?
Residential real estate has between one and four units and includes:
- Single-family homes.
- Apartments.
- Duplexes.
- Triplexes.
- Quadruplexes.
- Townhomes.
- Condominiums.
- Cooperatives.
- Individual mobile homes.
Families and individuals typically lease these properties (as opposed to businesses). Residential real estate involves finding tenants to live in these properties, and, after tenants move into the apartment or house, they pay rent to the owner each month. When screening tenants for a residential unit, the landlord should review the prospective tenant's previous rental history, credit, income, and various other details about their background to ensure they will be responsible, long-term tenants who will care for the property.
Marketing to longer-term renters decreases tenant turnover, causing less stress for the landlord. Long-term renters are more likely to treat a rental as if it were their own home, maintaining the property and general upkeep. These types of renters provide a steady financial income to investors, as well.
What is commercial real estate?
Commercial real estate properties are those with five or more units or any property used for business (as opposed to residential) purposes. This includes:
- Retail
- Office buildings
- Multifamily buildings
- Hotels
- Manufacturing facilities
- Warehouses
- Apartment complexes
- Vacant land that has the potential for development
Businesses and corporations typically tend to lease commercial properties, and a commercial lease agreement is used when securing tenants. Lease agreements tend to be more complicated at the commercial level and can include absolute net leases, triple net leases, modified gross net leases, and full-service leases.
Pros of investing in residential real estate
Property management tends to be easier
Depending on the situation, owning residential property tends to be less cumbersome at the residential level. Managing a single tenant, couple, or household can be far more manageable than managing a warehouse or apartment complex with hundreds of tenants. Depending on how many residential properties the landlord owns, it may not be necessary to hire a property manager to handle the assets. Rent collection and maintenance and repairs can be handled by the landlord directly. Of course, if the investor owns several residential properties, this may be difficult to manage independently, and a property manager may be necessary.
Tax benefits
Whether you own a residential or commercial property, landlords reap several tax benefits when they invest in real estate. Those who own property with tenants can deduct expenses associated with home repairs and improvements, rental income, mortgage interest, property management costs, and depreciation.
Cons of investing in residential real estate
Frequent tenant turnover
Residential leases can range from 12 months, 24 months, or a fixed term of 90 days to a month-to-month contract with no end date. Tenants in residential leases tend to be families, friends, roommates, and individuals. Because residential real estate typically involves renting someone their primary home, there is an emotional element involved in residential investing that isn't as common in the commercial sector.
On the flip side, commercial property is typically leased to businesses and tends to be more transactional than emotional. Additionally, because families and individuals tend to rent residential property, those who are only on six- or 12-month leases might not be as inclined to care for the property. In contrast, tenants who sign longer-term leases tend to respect the property and its rules a bit more.
Residential real estate investing pros and cons
| PROS | CONS |
|---|---|
|
• Easier property management. • Tax benefits. |
• Frequent tenant turnover. |
Pros of investing in commercial real estate
Low tenant turnover
Tenants in commercial properties tend to be businesses or corporations, with leases frequently lasting 10 years or more. As a result, commercial tenants are typically inclined to respect and maintain a property because they want their workplace to be a positive reflection on their company. Because commercial leases tend to be several years, an escalation clause can be incorporated into the lease, which requires the tenant to pay a share of the building's increase in costs (such as operating expenses, real estate taxes, etc.). These costs are in addition to the tenant's base rental payment.
Whether an investor is renting out a commercial or residential property, it is imperative that they carefully review the tenant's background, prior rental history, credit, and income to ensure that they will make all rental payments on time and will properly maintain the property.
Tax benefits
The tax benefits available to commercial property owners are similar to those found at the residential level. Owners can deduct repairs costs, rental income, property management costs, mortgage interest, depreciation, and various other costs associated with the commercial property.
Cons of investing in commercial real estate
Property management
Managing a commercial property (or several properties) independently can pose quite a challenge. Collecting rent and managing repairs/maintenance requests is far more demanding and complicated at the commercial level because there are more units and more complicated repair requests if the property is an office, industrial space, restaurant, etc. It is typically encouraged to hire a property manager when investing in commercial property to keep tenants happy and avoid frequent turnover.
Zoning
Zoning laws tend to be more involved at the commercial level, as commercial zoning has several categories. Regulations are dependent upon the business use of the property and often the number of business patrons. Vacant land that has the potential for development into a commercial building or buildings can be zoned as commercial. For example, in a commercial zone, ordinances may require a certain number of parking spaces or may regulate the number of similar businesses in the same district.
Commercial real estate investing pros and cons
| PROS | CONS |
|---|---|
|
• Low tenant turnover. • Tax benefits. |
• Property management challenges. • Zoning law complications. |
Residential real estate loan approval
Residential real estate loans (mortgages) are often more accessible to the average investor. By utilizing a government-assisted down payment loan program such as VA or FHA, residential properties can be purchased with a down payment as low as 3% of the property's purchase price, depending on the creditworthiness and income history of the individual purchasing the property. This loan debt is repaid in regular installments over a period of time.
The most popular residential mortgage is the 30-year fixed-rate mortgage, but residential buyers have other options that include fewer years for repayment. Longer repayment periods involve lower monthly payments, yet higher total interest costs over the life of the loan. Shorter periods entail larger monthly payments, but with lower overall interest costs.
Commercial real estate loan approval
Having good credit and a successful income history is a must for commercial loan qualification, but those aspects play only a small role in commercial loan agreements. Commercial loans are primarily underwritten based on an asset's projected net operating income, and eligibility for these loans has a lot to do with the property's performance. The length of a commercial loan typically ranges from five to 20 years, and the amortization period is often longer than the duration of the loan. Specifics of the loan repayment may be negotiable. However, the longer the loan repayment schedule, the higher the interest rate.
Key takeaways
Commercial and residential properties share some common traits in that they both have financing options, involve securing tenants, have various zoning ordinances, and -- when managed correctly -- can generate a sizable return on investment.
But residential and commercial properties have several differences as well. Commercial property tends to come with higher risk, as there are more units involved and more tenants. When investing in residential and commercial property, it is always imperative to conduct careful due diligence and speak with a financial advisor or real estate agent. Happy investing!
