Difference Between Investing in Commercial Real Estate and Residential
December 1, 2020
This year, housing experts forecast a 1.8% decrease in the sales of existing homes in the US. For the most part, this is due to the rising prices of homes and the increasing mortgage rates. As a result, more Americans are now renting than at any other point since 1965. All these have resulted in an increase in real estate property investors. Many are buying single homes and renting them out to families. Others are investing in commercial real estate and renting them out to many families -- all at the same time.
If you're interested in investing in real estate you need to know how commercial real estate differs from residential real estate. Ready to learn more about residential and commercial real estate investing? Then let's dive right into it!
What Is Residential Real Estate?
Residential real estate includes all single-family homes and one- to four-unit rentals. These include new constructions, such as the 1.27 million new housing units completed in 2019. Residential properties also include resale homes, condominium units, townhouses, and vacation homes. The primary purpose of residential real estate is to provide people a place to live in. You can use residential properties to produce income, such as if you rent out your home. However, residential properties are mostly for individuals and families.
What About Commercial Real Estate?
Commercial real estate includes any property that has more than four units. Multi-family homes with five or more units classify as commercial real estate. This type of real estate also includes condominium buildings, offices, warehouses, and hotels. The main purpose of buying and owning commercial real estate is to produce income.
Commercial vs Residential Real Estate Investments: Your Tenant Options As of December 2019, there were only 160.8 million housing units in the US. Of these properties, 65.1% are already owned. This alone limits your tenant options for residential real estate investments. On the other hand, you can rent out commercial properties to both families and businesses. If you buy commercial property, you can turn that into a multi-family dwelling or an office.
Investing in Commercial Real Estate May Generate Bigger Returns
Real estate investing can be lucrative, but it's important to understand the risks. Key risks include bad locations, negative cash flow, high vacancies, and problem tenants. One reason why commercial real estate attracts serious investors is the potential for a greater return. Studies show that commercial real estate investments produce an annual average of 12.7%. Homeownership, on the other hand, only has a 7.7% annual average return. Real estate investment trusts (REITs) produce even greater returns. In the same period (1986 to 2006), REITs had an average yearly return of 14.5%. Commercial properties, after all, allow for more tenants than residential rental units. The more tenants there are, the greater the potential.
Longer Leases With Commercial Real Estate
Lease agreements for residential properties often run between six and 12 months. Commercial leases, on the other hand, are usually set for at least three years. Some commercial properties can even have five- or 10 year-leases. Longer Leases Equate to Lower Vacancy Rates In the fourth quarter of 2019, the rental vacancy rate was 6.4%. The homeowner vacancy rate was 1.4%. In the housing market, these are often stable rates, due to short-term leases. Most leases, after all, don't renew automatically. In fact, automatic renewal is illegal in many states, with certain exceptions. That said, landlords or property owners have to look for new tenants when a lease ends. Again, that's usually after six or 12 months. That said, if you invest only in residential real estate, you run the risk of having a vacant property. Without tenants, your property won't make you any profits. What's worse, you'd still pay for maintenance costs and taxes even if no one lives in your property.
Since commercial real estate has longer leases, you will have lower vacancy rates. Of course, you'd still experience vacancy at some point, but not every after six or 12 months. Landlords, particularly in markets where rents are falling, will want to offer long-term leases for more stability and relatively consistent potential income.
Lower Vacancy Rates Mean Lower Turnover Costs
When a lease expires, property owners would need to put their property back on the market. This involves considerable costs, such as advertising and marketing. They also need to ensure that the properties are in good condition. These are all costs of "turning over" property to a new tenant. For residential real estate owners, these costs may arise each time a lease expires. Commercial investments may not put you in the same situation every year (or even twice a year). Your longer leases may protect you from these high turnover costs.
Better Tenant Quality With Commercial Properties
It can be difficult for residential property owners to find qualified tenants. Qualified in the sense that they have a low risk for non-payment. Moreover, it can be hard to find tenants who are sure to maintain (or at least, not damage) the property. Businesses and organizations are among the most common tenants of commercial properties. In short, they are professionals. Moreover, employers may have strict rules when it comes to property maintenance. This is why finding qualified tenants is often easier with commercial properties. It's also potentially easier to retain these tenants since they can't just get out of a long-term lease. There's also a potentially lower risk of non-payment, as most businesses have more stable finances.
Consider Taking The Leap and Investing in Commercial Real Estate Now
Now that you know how it differs from residential real estate, you can make a more informed decision. Ready to explore the potential of commercial real estate investments? Then please feel free to check out the app and connect with a friendly Concreit team member today.