Traditionally, new property investors start by investing in residential property as it is easy to understand. Investors also like the idea of getting in to a residential real estate deal with less money upfront compared to commercial property. But what is the best way to invest money in property – residential or commercial?
Commercial Real Estate
Commercial real estate is where the property is used for a business purpose. Examples of commercial properties are: Apartment complexes or multifamily, retail, office, industrial, commercial land, agricultural, hotel and motel etc.
Note: multifamily units are considered commercial from a banking point of view.
Residential Real Estate
Residential real estate is where the property is used as a residence for someone.
Pros and Cons of Commercial and Residential Properties
Commercial Property Advantages:
Residential Property Disadvantages:
Commercial Property Disadvantages:
Residential Property Advantages:
Lets Look at the Above Points in More Detail:
Property value in commercial real estate is directly related to the income it produces, thus a property without a tenant is less in value. So by finding a tenant for a commercial property, you can increase its value.
In residential property the mortgage is based on the borrower’s merit. The borrower traditionally has to provide a bucket load of documents to the bank. In commercial property the income of the property is what the lender will look for. The lender will also require all property income related documents and traditionally not the borrower’s documents.
In residential property the lease period is generally 12 months. In commercial property the lease period could be anywhere between 2 years and 20 years. The most common lease periods are 5 years and 10 years.
Each residential property you own will add to more management and overhead. In commercial real estate the management overhead is less; the tenant doesn’t call the agent or landlord for a broken tap or toilet. They get it fixed at their own expense.
In residential real estate there are government laws to protect the tenant. There are laws on how often you can increase the rent. In commercial real estate the contract stipulates the course of action and there is very less government interference.
Tenant’s Vested Interest in the Property
The tenant traditionally has some kind of a business running in a commercial property and has to keep it clean for its employees and customers. A commercial tenant also cares about improving the property for its business; they may paint the property at their own expense or may need to renovate to suit their needs. Most often these expenses are taken care by the commercial tenant and if there is a cost to the landlord then it has to be via agreement. In this scenario the landlord traditionally will increase the rent to compensate for the additional improvement cost. Guess who enjoys the increase in property value due to the improvements after the tenant leaves? The landlord, that’s right.
In residential property the owner is responsible for most maintenance costs and in commercial property the tenant is responsible for most maintenance costs. Maintenance cost for a commercial property when incurred can be higher. This of course depends on the lease and type of rental. There are commercial leases where all expenses are paid by the tenant and in some instances the landlord pays for the roof or the HVAC system (A/c unit) or maintenance associated with the car park. So when the landlord incurs these costs its traditionally more expensive than residential real estate.
Source of Rental Income
In residential property there is traditionally only one source of income unless the property has multiple occupancies. In commercial property there could be multiple income sources from multiple tenants. There could be additional income from storage spaces, warehouses, garages, even advertising spaces etc.
Time to Lease a Property when Vacant
A residential property when vacant can be rented out very quickly as long as the property is in reasonable shape and the rent is not too high. Finding a tenant for a commercial property may take time. Imagine you had a commercial property where the tenant was a restaurant. Now once this tenant vacates the property you most likely have to find another restaurant to occupy the premises. You cannot simply find any tenant. Do you think the premises will be suitable for an office? Not without major work. Even if you find another restaurant they may not like the size or layout and this either means a time delay or additional costs.
Loan to Value Ratio and Initial Investment
You can borrow more for a residential property, as high as 90% and thus your initial investment is very less compared to a commercial property. For a $300,000 property, this will be $30,000. For a $1 million commercial property where you can borrow 60% will mean an initial investment of $400,000.
There is no right or wrong investment choice, as in commercial or residential. It is simply a matter of what is your objective and strategy? How much is your initial investment going to be? What kind of financing can you get? All these answers will lead you to what you should be looking at investing. In commercial real estate there are various types and they have their own pros and cons. So you have plenty of choices and it’s just a matter of preference and what suits you. Don’t say no to commercial real estate just because of the initial investment as there are creative ways of getting in for a smaller investment. Think about syndications and creative financing options. Well those are topics on its own and for another day.