The choice between investing in commercial real estate versus investing in residential real estate is not an easy one. Each real estate investment strategy comes with its share of advantages as well as downsides. The decision a property investor makes will be determined by his or her preferred real estate investing strategies, liquid capital, risk tolerance, goals, and time.
What Is the Difference Between Commercial (Non Residential) and Residential Real Estate?
Commercial property could be industrial facilities (factories, warehousing and so on), offices, hotels, or retail premises. On the other hand, residential property comprises single family homes, townhouses, condos, multi family homes, apartments, duplexes, and quadruplexes. While commercial property is usually leased to businesses, residential rental property is leased to individuals and families looking for a place to live.
Here are some factors to consider when choosing between commercial vs residential real estate investing:
Commercial vs Residential Lease Terms
Commercial properties have longer leases compared to residential investment properties. While residential leases usually run for 1 year, a commercial lease could be anything from 3 to 10 years. A longer lease is beneficial for the following reasons:
- Lower turnover costs
- Lower vacancy rates
- More predictability in cash flow
Related: How Much Cash Flow Is Good for Rental Property?
Of course, long leases also come with their own downsides. For instance, if you have difficult tenants, it will not be easy to break a long-term lease. However, for a residential real estate investment property, you can simply choose not to renew the short-term lease.
Commercial vs Residential Performance in Economic Downturns
When there is a downturn in the economy, some of the first people to suffer are retailers. Even when the economy is doing well, businesses still experience a high rate of failure. Therefore, though your commercial property has a long lease, you cannot be sure that your tenant will even be in business for the whole period.
On the other hand, regardless of the state of the economy, people will always need a place to stay. Therefore, residential real estate owners are not affected as much as retail real estate owners when there is an economic downturn. Investing in rental properties will therefore ensure a passive income even in bad economic times.
Commercial vs Residential Real Estate Barriers to Entry
Many people have paid rent at some point in their lives. Therefore, they have a pretty good idea of the tenant/landlord relationship. Since residential real estate is easier to understand, it is very easy to start investing in. It doesn’t take much money or experience to start investing in residential properties.
On the other hand, commercial property transactions are very complex and need much more research to understand. In addition, buying a commercial property is riskier and requires a lot of money compared to residential real estate.
Commercial vs Residential Real Estate Tenant Pool
In recent years, the retail sector has not been performing very well all over the world. Besides competition from large stores such as Walmart, retailers have also faced increasing competition from online stores that offer the same products more conveniently and at a cheaper price. This has resulted in many retail stores shutting down and commercial rental prices dropping drastically. Nowadays, it can take up to six months to find a tenant for a commercial space.
With the increase in population all over the world, the demand for residential rentals continues to rise. Many millennials prefer to rent for a longer period before purchasing homes. In many places like the Los Angeles real estate market where the renter population is high, it may take only a month or less to find a renter. As a result, residential rental properties experience a lower vacancy rate compared to commercial real estate.
Commercial vs Residential Real Estate Analysis
When it comes to residential real estate, you can make money through appreciation, cash flow, and building equity through paying off your mortgage. Residential property owners should not find it very difficult to understand and analyze simple metrics such as capitalization rate, cash on cash return, and return on investment. And they have plenty of online tools like rental property calculators to help them out.
Related: The Ultimate Rental Property Analysis Calculator
However, commercial properties require analyzing more than just these basic valuation and acquisition ratios. You will need to get other details such as rental history, profit and loss statements, and maintenance records, which usually are not available from a real estate listing.
Commercial vs Residential Loans
While residential mortgages are usually between individual buyers and banks, commercial mortgages are offered to companies. Since lenders deem commercial loans to be riskier, such loans usually have shorter terms and higher interest rates. In addition, to qualify for a commercial mortgage, real estate investors must have a good credit score and a solid business plan. The lender will want to know the investment property’s projected cash flow, what maintenance will be needed, who will pay utilities, and other details before approving the loan.
The terms, conditions, penalties, and restrictions for residential loans are less strict compared to commercial loans. Residential rental property buyers have more loan options and a longer period to repay their loans.
Commercial vs Residential Electricity Rates
Commercial properties are often leased to businesses that use heavy machinery. As a result, electricity consumption is usually much higher compared to residential properties. However, electric companies often provide discounts since commercial property owners purchase electricity in bulk.
Commercial vs Residential Return on Investment
No average return on investment applies to all types of rental properties. The return is influenced by factors such as property type, location, property management costs, and vacancy rate. For example, a residential property in the California real estate market could perform better than commercial property and vice versa in Indianapolis. Investors compare commercial and residential properties by looking at metrics such as cash on cash return and cap rate. Typically, residential investors look for a cash on cash return of 8-12%, while commercial investors aim for a CoC return of 10%.
Related: What Is a Good Return on Investment for REI?
Though making a decision between commercial vs residential real estate is not easy, the pros and cons listed above will help you choose wisely. Based on all these considerations, it is far much easier to invest in residential than commercial real estate. You can find and analyze a wide range of rental properties for your real estate business on Mashvisor.
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