Should you invest in residential real estate or commercial real estate?
Real estate investing can offer great rewards to those willing to take the financial risk on residential or commercial properties. Whether you choose to invest in one type of real estate or diversify your portfolio with both depends on your investment objectives, your short or long term strategy and your level of risk tolerance.
Here, we’ll look at the differences between the two types of real estate investing and the pros and cons of each to help you decide which is right for you.
Commercial vs residential real estate investment
Residential real estate covers a variety of housing types, including condos, co-ops, townhouses, mobile homes, single-family homes, and multi-family homes with four or fewer units.
The five main types of commercial real estate are retail, office, industrial, multi-family and special purpose buildings; the latter includes hotels, hospitals, and amusement parks, among other dedicated-use properties. Generally, a residence of five or more units is considered commercial and non-residential real estate; student housing and apartment complexes are included in commercial real estate.
Although we’re focusing on direct ownership and management of commercial properties in this article, real estate investment trusts (REITs) are another investment opportunity. This is a great opportunity for real estate investors to add commercial investments to their portfolios without any direct owner liability.
So what are the advantages and disadvantages of the different types of investment? Here is an overview.
Benefits of Commercial Real Estate Investment
Triple Net Leases (NNN)
Commercial real estate often operates on triple net leases (NNN). This means that in addition to tenants paying rent, they will also pay their share of property taxes, insurance and general operating expenses. Since these costs are much higher than those incurred by residential real estate, it is good to know that your tenants are footing the bill.
Longer rental periods
While we’re on the subject of leases, here’s another big plus: commercial real estate leases typically last five to 10 years — and sometimes even longer. The ability to determine cash flows over longer periods is one of the main advantages of commercial real estate.
Additional sources of income
Savvy investors will find many other ways besides rent to generate cash flow in their commercial properties. A laundromat in an apartment building and vending machines in an office lobby are just two of the many examples of passive income available to commercial real estate owners.
Disadvantages of commercial real estate investment
Greater financial investment
It costs a lot more to invest in commercial property than residential property, and it can be difficult for new investors to get loans without a large down payment, usually between 20% and 35%. There are also higher costs in maintaining the property. While these are covered by your tenants’ rental fees, you’ll have to pay operating costs as well as your loan repayments if you can’t rent the space.
Risk is inherent in either type of real estate investment, but it is even more so in commercial real estate. In addition to dealing with tenants, you may also need to worry about public access to your property. From theft and vandalism to on-site injuries sustained by employees or customers, there are many more potentially risky issues that commercial investors have to deal with than residential investors.
More responsibilities and work
Beyond the risks, the day-to-day management of a tertiary property is more complex, and therefore more time-consuming, than the management of a residential property. You will likely need to hire a property management team to take on the responsibilities. You will have peace of mind working with professionals, but paying them will reduce your profits.
Advantages of residential investment
While the pandemic has shown us that people don’t always need an office to work in, people will always need a place to live.
Easier adjustment of rents
Residential real estate leases tend to be for one year or even less, which means landlords have the flexibility to adjust rental rates depending on the economy. Unlike long-term commercial real estate leases, if the value of the property increases, residential investors will be able to increase rents sooner.
Less work and money to maintain
To be clear, maintaining a home is not without its responsibilities and expenses. But they are generally fewer in number and less intense than those of commercial real estate. A power outage in your single-family rental is still a problem, but not as much as if an entire building lost power.
Disadvantages of residential investment
High vacancy rate and turnover
Shorter rental terms in residential real estate mean faster turnover and higher vacancy rates. An office investor can probably stay afloat despite vacant units, but if you’re between residents for your single-family rental, you’re operating at 100% vacancy with no cash flow.
Strict rental laws
There are many laws in place that protect tenants at the expense of landlords. In particular, during the pandemic, a moratorium on evictions prevented landlords from evicting tenants in arrears with rent. While residential property investors must act responsibly in the interests of tenants, this can put them at risk of not being able to cover their own bills.
Limited ways to add value
Residential real estate investors simply don’t have access to the many streams of income that commercial investors have. Yes, home improvements and upgrades can justify higher rents and increase property value over time. But those upgrades would likely happen when the unit is unoccupied, meaning there’s no rent while the money is spent.
Real estate investing has its risks and rewards
Both types of real estate have obvious advantages and disadvantages. Demand is high for housing, which is good for current investors, but low inventory makes it difficult for new investors to add properties to their portfolios. Meanwhile, commercial real estate has taken a hit during the pandemic. The office and retail sectors are still struggling to recover, although the industrial and multi-family sectors are booming.
As an investor, it is important that you do your due diligence with all real estate opportunities to understand the risks involved in owning and managing residential or commercial properties.