If you hang around online forums for real estate investors, it's easy to assume that everyone starts with residential properties, but if you really want to be a successful real estate investor, you need to move to commercial.
It seems most investors believe that residential real estate is the kiddie pool and “mature” real estate investors turn to commercial as soon as they've accumulated enough experience and have access to enough funds.
But is commercial real estate better than residential?
I've been researching this question for some time now. As it turns out, there are staunch supporters and convincing advocates on both sides of the debate.
So let's take a look at where the two strategies differ…
It's Easier to Increase the Value of a Commercial Property
The market value of a residential property is determined by the average value of comparable properties in the neighborhood. This is based primarily on raw characteristics such how many bedrooms and bathrooms there are. So in general, a two-bed, two-bath property with top-of-the-line appliances has about the same value as another two-bed, two-bath house on the same block that has a very basic kitchen.
Commercial real estate is valued with a more precise approach. Sure, local comps are considered. But the market value is based almost entirely on the amount of revenue generated by the property itself. So a strategic yet inexpensive improvement can have a huge impact on a property's resale value if it increases the revenue generated by the commercial property.
Enjoy Longer Lease Terms With Commercial Properties
Commercial leases are much longer than residential leases. Residential leases often run 12 months. A commercial lease is typically at least three years. Leases for five and 10 years are not uncommon.
The benefits of a longer lease are:
- More assurance of reliable cash flow
- Lower vacancy rates
- Lower turnover costs
Of course, there's a downside to longer lease terms. If you're unhappy with a tenant, it's easier to simply not renew a short-term lease (and make them leave) than it is to break a long-term lease.
Residential Properties Perform More Consistently in Economic Downturns
Residential properties weather economic downturns much better than commercial retail space does. When there's a market downturn, retailers are usually the first to suffer, and they can be hit hard. Even in good economic conditions, small business owners have a high failure rate. So, though you have longer leases with commercial properties, there's no guarantee that your retail tenant will be in business for the entire term of the lease.
No matter what the economy is doing, people need a place to live. And when there's a downturn, residential property owners don't suffer as much or as quickly as retailers. Renters place a high priority on paying rent so they can be sure they have a place to call home.
Residential Real Estate Investing Has Lower Barriers to Entry
It's easier to get started with residential real estate investing, because it's easier to understand. Most of us have been renters at some point in our lives. We understand the landlord/tenant relationship. We're familiar with what's expected on both sides of the table. It takes very little experience — and a lot less money — to invest in residential real estate.
Commercial deals are a lot more complicated and require a lot more research to find and evaluate. Purchasing a commercial building takes far more money than to buy a single-family home. And the risks are higher. For one thing, there's a lot more money on the line. And all that money is invested in a hard asset that can't be physically moved or readily liquidated.
The Buyer Pool Is Larger for Residential Properties
The retail sales sector of the U.S. economy has not been performing well when compared to other sectors. Retail stores face stiff competition from the big box stores like Walmart. And there are also online retailers that can often deliver the same products cheaper and much more conveniently.
There are of empty commercial spaces in many parts of the country. There just are not enough retail tenants to fill them all. This drives down the rental prices. And it often takes an average of six months to rent out a commercial space. This is a factor that increases the cost of vacancies.
On the other hand, residential rentals have a steady demand in most of the country. Everyone needs a place to live. And many Millennials are renting longer before buying homes. It takes less time to find a renter. It often takes just 30 to 45 days in most markets. I recently rented one of my properties with no vacancy time. One tenant left on June 30, and a new one moved in on July 1.
Commercial Deals Are More Complicated to Analyze
You can make money with residential real estate investing in three ways: cash flow, appreciation and equity buildup through paying down a loan. With residential real estate, it is helpful to understand common ratios like return on investment, cash-on-cash return and capitalization (cap) rate. With commercial properties, you need to understand and evaluate these plus other metrics.
Commercial real estate investing is more like owning a small business. The most important thing to making money is increasing your net operating income. In addition to other acquisition and valuation ratios, you need to get details like maintenance records, expenses and rental history, which are often not found in a listing. And just as important are the operational ratios and analysis. You need to be looking at the last 12 months of profit-and-loss statements.
Which Is Easier to Finance?
On this point, I've read conflicting information from seasoned investors. One side says that it's easier to secure large amounts of capital for a commercial deal than to generate lower amounts for residential properties.
But the other side says that many banks are reluctant to lend on retail commercial spaces, because they are seen as a higher risk due to the online retailer effect.
One key factor affecting financing is location. Some metropolitan areas are booming, but others are in the depths of an economic rut. The consensus of the commercial lenders where I live seems to be that the banks are not interested in writing a loan unless there are tenants with long leases already in place. So, there are not a lot of good deals. If an owner already has a property with solid tenants, why would they sell?
Which Delivers a Better Return on Investment?
Investors and experts disagree on the numbers when it comes to return on investment. Residential investors in my area aim for a cash-on-cash return of 8–12% after all expenses. Investors in some parts of the country wouldn't even think about a rental property if it didn't promise a return of at least 15%.
The return on investment also varies from one kind of property to another. No average applies to all rental properties. It depends on location, property type, vacancy rate, property management costs and other factors.
For commercial properties, investors compare properties by looking primarily at cap rate and cash-on-cash returns. Again, there's a lot of variance based on location and type of property, but the consensus seems to be that commercial investors aim for a cap rate of 8–15% and a cash-on-cash return of 10%.
I'm Sticking With Residential… for Now
It's crucial to keep your risk to a minimum, whether you're investing in residential or commercial.
Commercial real estate requires a larger cash outlay. And you're putting all your eggs in one basket if you can afford only one commercial property. With residential properties, you can spread out your risk and diversify across multiple types of properties located in different areas.
I've learned that investors can make — and lose — a lot of money in every niche of real estate. Those who do well pick a niche they understand, become an expert in their niche and execute a sound strategy within that niche. Rookies who jump in because they saw someone else make money and believe it must be easy end up losing.
At this point in my investing career, I'm going to stick with residential. I have experience in that niche. Also, I believe it's riskier to put all my funds into one commercial property than to spread my risk across many residential properties. It's not as big a financial setback if you miss your mark with one single-family home. It's a much higher cost to miss the mark with a commercial building.