Commercial vs Residential Real Estate: What's the Difference?
June 15, 2022
If you've invested in real estate for a while and think commercial real estate is better than residential and it's time to move on, it's time to compare commercial vs residential real estate.
While the idea seems better and the ROIs seem like they should be higher with commercial real estate, there's a lot more to consider when choosing residential vs commercial real estate.
What Is Commercial Real Estate?
Have you asked yourself, 'what is commercial real estate?' You might be surprised to learn what it is and isn't.
Commercial real estate is any building with five or more units (such as an apartment building) or any building used for business purposes. You can use the real estate yourself to run your own business or rent it out to tenants with the help of a real estate agent.
When looking for a commercial building investment, the sky's the limit. A few common uses for commercial properties include:
- Office buildings
- Manufacturing facilities
- Healthcare facilities
- Retail stores
- Shopping malls
- Apartment complexes
- Qualified Tenants
Any tenant could default on their rent, but business owners are more likely to follow through on their obligations. With business tenants, you can ask for references, look at their financial records, and assess their business model to determine if they'd make a good tenant in your commercial rental.
- Longer-Term Leases
Business owners don't want the hassle of moving every year. They're more likely to sign long-term leases, with the average term of 5 years. This gives you more predictability and requires less work when trying to fill your commercial property.
- Less Work
Commercial property owners are on call, just like residential real estate landlords. However, business owners typically don't work 24/7, so you may get fewer 2 AM phone calls if something is wrong.
- Higher Rental Income
Commercial rental properties tend to bring in more rental income because of the larger square footage and property value. For example, the average rent for a 2-bedroom home is $2,065, but the average rent for a commercial property is $37.37 per square foot, for an average of $4,671 per month for a 1,500 square foot property.
- Higher Values
Commercial property values, unlike residential real estate, is based on the business's net operating income. Therefore, if you do your due diligence and get the right business in your commercial property, it's easier to increase your property value.
- Harder to Start
Investing in commercial real estate requires a lot more capital than investing in residential real estate. Most retail investors can't afford to invest in commercial properties on their own, even with financing.
- Lenders Don't Easily Finance Commercial Properties
Most' regular investors' can't get financing from commercial real estate investing unless they have a proven history of successful commercial property before. Even then, lenders require large down payments and have shorter terms (some as short as five years).
- Commercial Buildings Are More Susceptible to Economic Downturn
If the economy suffers, like it did during the pandemic, businesses usually suffer the consequences first. If business owners can't pay their rent, it negatively affects commercial real estate investors.
- More Complicated to Manage
A commercial real estate investment is subject to many more zoning laws than residential real estate. Therefore, there may be more permits and red tape to fight when looking for a commercial property investment than would be necessary with residential real estate.
- Harder to Sell
Selling residential property is a lot easier than selling commercial buildings. There's often a great demand for residential homes, whether from other real estate investors or people looking for an owner-occupied property. Commercial properties don't have the same demand. They require a much more specialized group that may not be as prevalent.
What Is Residential Real Estate?
Residential real estate are buildings with between one and four units for people to live. Not all properties used for residential purposes are consider residential property, though. They must not have more than four units to fall into this category.
Common examples of residential properties include:
- Single-family homes
- Multi-family homes (up to 4 units)
- Mobile homes
- Anyone Can Invest
Residential real estate doesn't require as much capital as commercial properties require. With as little as 20% down ($20,000 for every $100,000 you borrow), you may be eligible for financing, and you don't need any special knowledge or history to run residential real estate.
- Shorter Term Leases
Residential leases are usually good for one year. This gives real estate investors a chance to adjust to the current times. For example, during inflationary periods, you can increase rent to reach the average market rent. You can also improve the property value and increase rent for that purpose.
- Fewer Issues During Economic Downturn
When comparing commercial vs residential real estate, residential real estate is much less likely to be affected by economic issues than commercial properties. Business owners usually suffer first, which means commercial real estate investors feel the loss before residential real estate investors. People need a place to live, so they're more likely to keep up with their rent on a rental property.
- You're on Call 24/7
Looking at residential vs commercial real estate, residential real estate requires a larger time commitment from investors. You're more likely to get those 2 AM phone calls when something is wrong with the property than you would with a commercial property whose business owner isn't there 24/7.
- More Frequent Tenant Turnover
Shorter leases mean more turnover. This could mean more work for you as you locate and screen new potential tenants. It can get tiring constantly looking for new tenants, especially if you have tenants that vacate the property before the lease expires.
- Higher Competition
Since residential properties have a much lower barrier to entry, the competition is much stiffer. Not only is it harder to get residential properties, but it might be harder to find tenants to live in your rental properties if the area has a lot of real estate investors.
- Property Values Depend on the Market
Residential real estate values depend on the sales price of recently sold homes in the area. If the area had a lot of foreclosures or sellers that sold for less than the home is worth, it could affect your property's value, giving you a lower return on your investment.
Commercial vs Residential Real Estate
When comparing the idea of commercial vs residential real estate, it's important to look at the big picture including the following factors.
Understanding your financing options is important. Residential real estate financing is pretty straightforward. You can apply for a fixed-rate loan with a 30-year term. The rates may be higher than a primary residence loan and you'll need a larger down payment (usually 20% - 30%), but it's easy to get financed.
When learning how to buy commercial real estate, you'll see that financing is more difficult to obtain. You'll need upwards of $1 million, which means much larger down payments (20% of $1 million), great credit, and low debt-to-income ratios. Commercial real estate financing is much harder to come by.
You'll owe property taxes no matter what type of property you own - a commercial rental or residential rental property. Probably not surprising, residential real estate taxes are much lower than commercial real estate taxes, so make sure to figure that into your budget when deciding.
Analyzing commercial and residential properties for rent is an important part of the decision-making process.
Residential real estate investing relies on monthly cash flow, property appreciation, and how much equity you can accumulate as you repay the mortgage loan. You should look at metrics such as cash-on-cash return and cap rate too.
A commercial real estate investment requires the same metrics as residential real estate investing plus you should think about things like the rental history of the building, maintenance records, and financial details about the business thinking about renting your property.
Barriers to Entry
Finding a commercial property to rent may not be difficult, but having the capital and qualifications to buy it may be a lot more difficult than buying a residential property. You need a larger down payment and more qualifications to prove you can afford the higher monthly payment and have the expertise and history to manage a commercial property.
Residential real estate investing is much easier. You can usually find financing at your local bank or an online lender with 20% - 30% down and average debt-to-income ratios. You don't need a history of owning rental property or to prove you have the expertise to manage the properties. Residential property investments are for the everyday investor, and commercial real estate isn't.
There's risk in both commercial and residential real estate investing, but the risk is higher with commercial properties.
Since businesses are more prone to economic downturns, commercial real estate investors are at higher risk. If a business fails, they won't be able to pay its rent which can cause your real estate business trouble.
Plus, since commercial leases tend to be longer-term than residential ones, you could be stuck in a lease with lower than market rents or a difficult tenant for as long as five years or more.
This doesn't mean residential properties are without their risk. No tenant is perfect, and there is plenty of tenant turnover in residential leases too. There's always the risk of taking on a bad tenant, a tenant breaking a lease, or being unable to fill the property, leaving you with the cost of owning the property without any income.
Commercial leases usually run much longer than residential leases. Some see this as a benefit and others prefer shorter-term leases. Think about what makes you feel more comfortable. Do you like knowing you have a tenant for the long-term or would you prefer more frequent tenant turnover?
Residential leases usually run on an annual basis, but every landlord can choose the terms they offer.
Return on Investment
The return on investment varies not only with commercial vs residential real estate but also by location. No two investors have the same ROI requirements either. Think about what ROI would help you sleep better at night and do your due diligence to see the average ROI for commercial vs residential properties in your area.
Owning residential and commercial property both require a large time commitment. If you manage them yourself, consider yourself on call 24/7, even if a business doesn't operate 24/7.
Commercial buildings, though, are harder to manage yourself since the scope of what could go wrong could be outside your expertise. You may have to spend more on contractors and/or property management costs to manage commercial properties for rent versus residential properties for rent.
Commercial vs Residential Real Estate FAQ
Are Commercial Loans Different From Residential Loans?
Commercial loans are riskier for lenders because commercial real estate investing is riskier. There's a higher chance your tenants could break the lease if their business fails, which puts commercial lenders at higher risk. As far as borrowing the funds and paying interest, the premise is the same, but you'll pay more interest and financing costs with a commercial real estate loan.
Which Is Easier to Finance, Commercial or Residential Real Estate?
Financing residential properties is much easier than commercial real estate because of the lower cost. Most lenders require 20% down for both types of properties, but 20% of $1 million is much more than 20% of $200,000 that a residential real estate property might cost.
What Is the Difference Between Passive and Active Investing In Commercial and Residential Real Estate?
Active investments in commercial and residential properties mean you own the properties, rent them out, and manage them. You are the person they call when something is wrong with the property, and you are in charge of finding, screening, and managing tenants.
Passive investments in real estate means you invest money into a real estate company that handles the active part of real estate investing. Then, you just sit back and earn dividends and potential profits if the property performs well.
Residential vs Commercial Real Estate: Which Delivers a Better Return on Investment?
There's no cut-and-dry answer regarding commercial or residential property regarding ROI. The actual ROI depends on the area, the research you do, and the demand at the time you invest. Ideally, both would offer an ROI of 8% - 10%, but there's never any guarantees.
The Bottom Line
Look at the big picture when comparing commercial vs residential real estate investments. Don't assume commercial investments are better, but also don't ignore the opportunity. Do your due diligence and, most importantly, decide whether you want an active or passive investment in residential or commercial property? Learn more by signing up and visiting our blog.
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