It is important to understand differences between commercial vs residential real estate investing. They are completely different kettle of fish.
Residential real estate investment, as the name suggests, is investing in property that people use primarily for residential accommodation. These include apartments, town houses, free-standing homes, duplexes, condominiums and apartment buildings.
Residential real estate investment is comparatively less daunting than commercial real estate when starting out your journey because everyone knows what constitutes a home that some could live in. You will straight away notice absence of a bathroom and a kitchen or if the property suffered from poor ventilation.
Commercial properties include offices, industrial sheds, free standing retail shop, bulk retail, block of shop, medical centers, service stations, motels, hotels, back packers, health clubs, churches, funeral parlors, child care centers, car yards, convenience stores, shopping malls, to name just a few. Each type of commercial real estate investment has its own peculiarities, strengths, problems, rewards and risks.
In addition, you have to deal with contracts and leases that can affect the price of the property.
Commercial real estate investment is the natural progression from residential property investment. Experienced property investors tend to move into commercial real estate sooner than later – and for very good reasons.
Once your portfolio grows, it is very difficult to manage your investments if a large portion of them is tied in residential properties. Imagine you have $15 million worth of residential properties – that would be lot of homes and tenants to take care of.
On the other hand, $15 million will buy only a very small number of commercial properties, which will be comparatively easier to manage with much lesser overheads.
In residential real estate investment, you are essentially dealing with people. Unfortunately, people create problems. Your tenant will ring you up at all odd times with even the smallest of complaints: at times, the rent is not paid in time, the lawns are not mowed or they will not keep the property clean and in worst cases, they damage your property.
Residential tenants have little or no interest in maintaining your property.
“The working components of a rental home (heating, cooling, electrical, plumbing, dishwasher, garbage disposal, doorbell and refrigerator) will break down 90% faster on the rental than the working components of your own home.”
If the tenant is not complaining, then you will find the neighbor complaining about the tenant for making too much noise or their children running into the neighbor’s property. So you need people skills to manage your property or you will need to employ a property manager.
“The sweet little girl with the baby you rented your house to will always have an abusive boyfriend, and their loud, passionate lovemaking at night, nasty quarrels and scream fests will be the talk of the neighborhood.”
If you have ever worked as a landlord—this reason will be very clear to you: residential tenants complain about everything on earth and mostly in the middle of the night or when you are watching a good game of football.
Commercial property on the other hand, is a space for doing business. It is a place from where a tenant sells his products and services. The success of his business depends on the presentation of the property and number of visitors they receive each day.
The tenant bases his monthly rent on a commercial property on a certain percentage of the profit the business makes each month. When a businessman approaches you to rent a property, they do so because the location is suitable to them.
The tenants know the value of a good location and they will pay to be in the right place.
Most commercial property tenants will fix problems and carry out minor repairs on their own without calling the landlord. This is because they realize that problems need to be taken care of immediately or they will interfere with their business. Residential tenants on the other hand, will always look for help from the landlord to take care of repairs—they will never spend a dime on the property.
Commercial property tenants can spend substantial money to upgrade the property for their business requirement. These improvements stay with the property long after the tenant has moved on.
Most commercial tenants need to put in networking and cable wires, sound systems, and electrical outlets – all of which increase the market value and marketability of your commercial property.
In commercial property, you tend to deal with contracts where as in residential real estate investment you tend to deal with people.
The biggest advantage of residential real estate investment is that it is easy to find a new tenant once your property becomes vacant, which reduces the vacancy rate and there is always cash flow coming from your investment.
There is only one reason for your property to remain vacant for too long: your rents are too high for that location at the particular time. If you drop the rent by 5–10%, you will normally find a tenant, which is because people have to live somewhere at affordable costs.
In commercial real estate, properties are far more specialized and in case of a vacancy, you may not find a tenant for months or even a few years: this is a huge risk for a new investor who is not familiar with real estate investment and requires deeper pockets in case of vacancy.
Return on Investment
The return on investment in commercial real estate is much higher than residential property: the income is net and not gross because the tenant pays all the outgoing expenses, and is also more stable because of the long leases.
The rate of return on residential real estate investment is much lower because in residential property, the owner has to pay all the outgoing expenses such as property rates, insurance, body corporate fees and maintenance costs. In commercial real estate, it is the responsibility of the tenant to pay these costs thereby increasing net returns.
It is typical to have returns of around 7–10% net for a commercial real estate investment and anywhere from 5–7% net return for a prime property.
The net return from residential property tends to be from 2–6% and can be a bit higher in less desirable neighborhoods and apartment buildings.
Value of Property
The value of a property is determined by its location, land size and improvements. This is true for both residential and commercial property.
What is peculiar to commercial real estate is that its value is also greatly determined by the quality of the lease. In general the value is determined by taking net contractual rental being paid and use of a capitalization rate to arrive at a value. The value is also determined by the quality of the tenant and length of the lease.
There is a saying in commercial real estate: “More leases you read in bed the richer you will become.”
The value of a commercial property can drop substantially if it becomes vacant. Often commercial properties are sold at 10–50% of their value if they are difficult to lease.
The value of residential real estate on the other hand, is determined to a large extent by location of the property. If the house is in a desirable area, it will command a better price.
Residential property leases tend to be very short when compared to commercial leases that can run for several years. As discussed earlier, it is much easier to find a tenant for vacant residential property.
Commercial real estate financing is harder to get as banks look at the quality of tenants, length and terms of lease.
In general, commercial properties are more expensive than residential properties. Banks will lend up to 90 % or more on residential properties and only up to 50% to 70% on commercial property. You will therefore need more equity to buy. This reduces your leveraging power to buy more property.
The lending rates are also marginally higher, which reflects the risk that banks associate with commercial real estate investment.
You will require much lesser seed capital to start with residential real estate investment, and will be able to leverage your money better with residential property.
Government laws with respect to residential property are far more stringent and can override anything that you may have written in the rental agreement with the tenant. Politicians and bureaucrats put these protections in place so that residential tenants are not exploited.
In some countries and states the laws are so much in favor of the tenant that you cannot evict them even in case they are behind on their rents.
Real estate law is more flexible towards commercial lease contracts. You can insert any clauses in the sale or lease agreement that is agreeable to the contracted parties without any interference from the governing agencies.
It is common to charge penalty interest on the outstanding rent or lock the premises on continued default of rent.
Property Management Costs
Residential real estate investment management takes time and effort because you deal with people. Once you have several residential investments, it can become a full-time job.
Residential property managers charge anywhere from 6–8% of the rent collected towards the management fee.
Commercial properties on the other hand, do not require much of your time in managing them. Commercial tenants usually stay in the property for many years and it is in their best interest to maintain and make improvements to the property.
Commercial property management is also much simpler because tenants have a strong vested interest to maintain the property to a high standard: they usually derive their income from the property. They have to keep the property looking good and maintain functionality to impress their clients.
Commercial tenants spend hundreds of thousands of dollars to make improvements to the property. Most of these improvements stay with the property long after the tenant has left the property.
Commercial property management fees reflect the reduced work involved and charges range from 2–6% of the rent collected. The best part is that you can charge the management cost to tenant as a part of the out goings. In case you choose to manage the property then the management charges become payable to you thereby increasing the return from the property.
Risks and Rewards
So far, the biggest risk in commercial vs residential real estate investing is finding a new tenant in case of a vacancy. In commercial real estate, the requirement of each tenant in terms of size, location, use and rent payment capacity is so different that it is very difficult to get the right tenant for the right property.
For the reasons mentioned above, it is also difficult to sell or lease a commercial real estate investment. Higher the value of property, lesser the number of investors to buy the property.
A commercial real estate investment is less liquid than other investments because there are very few players in the market. For a residential house, there will be hundreds of potential buyers, which is not the case with commercial properties.
Commercial real estate investments are generally sold on capitalization rates and rarely on replacement value. It is therefore possible to purchase a poorly rented commercial property well below its market value. You can also increase the value of your commercial real estate simply by leasing the property or raising the rents during rent reviews or renegotiating the lease terms when it come up for renewal.
Commercial real estate investment provides professional investors with the opportunity to put their energy because of the higher returns and ease of managing them. For these investors, commercial property is their ‘bread and butter’ and they drive their speculative income by trading in residential properties.
Some commercial investors focus their attention to improve and add value to their commercial portfolio. Whilst others use their rental returns to fund development projects that show much higher returns, they need different and more advanced skill sets.
Here are my final thoughts about Commercial vs Residential Real Estate Investing. Commercial real estate investing is very rewarding but requires more knowledge, experience and capital out lay. It is not advisable to jump into commercial real estate from the very out set until and unless you have very deep pockets and risk taking ability. It is advisable to start with residential real estate investment to build your equity and cash flow.
You should buy at least 8–10 residential property investments before venturing into the world of commercial real estate investment that is far more complex.
For a new investor, it is very important to know the fundamental principles of real estate investing, thus making it much easier and less risky to get started with residential real estate investing because of the easy in understanding residential property, getting the finances, leveraging money and managing vacancies.