One of the first choices that must be made by potential real estate investors is what type of real estate to invest in. At the highest level, there are two options: commercial and residential.
In this article, we will define both commercial and residential real estate, identify the key differences between the two, and describe the pros and cons of investing in each. By the end, readers will have the information necessary to determine which asset class is most suitable for their own investment objectives.
At First National Realty Partners, we believe that real estate deserves an allocation as part of a broadly diversified portfolio of risk assets. To learn more about our current investment opportunities, click here.
What is Residential Real Estate Investment?
For investment purposes, residential real estate is defined as any property with 1-4 units and a residential use. Practically, this includes: single family homes, duplexes, triplexes, quadplexes, and condos. Residential properties with more than four units fall into the commercial category.
Residential properties are typically located in areas and neighborhoods that are zoned for residential uses, which could be in an urban core or in the suburbs.
There are three common residential real estate investment strategies:
- Long Term Rental: With this strategy, properties are purchased and rented on a long term basis to individuals or families. A typical residential lease has a term of 12 months.
- Flip: In a flip strategy, a property is purchased, renovated, and sold to another buyer at a higher price. A “flipper” does not seek long term cash flow, rather they profit from the difference between their acquisition cost (including renovations) and the sales price.
- Buy/Renovate/Rent: The third option is for an investor to buy a property at a favorable price, renovate it, and then rent it on a long term basis. This particular strategy is common in fast growing markets where older properties need to be brought up to market expectations.
No matter the strategy, there are a number of benefits to investing in a residential rental property.
The Pros of Investing in Residential Real Estate
The potential benefits of residential real estate investment include:
1. Low Barriers to Entry
Residential properties tend to be less expensive than their commercial counterparts and financing is widely available with favorable terms. Combined, these factors allow individuals to acquire a suitable residential property with a relatively small down payment.
2. Housing is a Primary Need
A safe, clean place to live is a primary concern for many. For this reason, residential renters tend to prioritize rent payments in times of economic distress. For investors, this means a relatively stable stream of cash flow through all phases of the economic cycle.
3. Small Number of Tenants
The maximum number of tenants in a residential property is four (a quad-plex), which is a relatively small number to manage on a monthly basis. In many cases, day to day property management is handled by the individual owner/investor.
Because of their relatively low prices and widely available financing, residential properties appeal to a larger pool of potential buyers for a simple reason, there are more people who can afford them. As a result they tend to sell faster, which provides a degree of liquidity that isn’t always available with commercial properties.
5. More Tenant Prospects
Everyone needs to live somewhere. For this reason, residential property owners have a large pool of potential tenants to rent their investment property. Practically, this means residential properties can find tenants relatively quickly, which reduces loss to vacancy over time.
6. Lenient Zoning Laws
Local building codes and municipal zoning laws tend to be more lenient for residential properties. This provides owners/investors with more freedom to perform certain renovations to keep their property in good condition. However, it should be noted that zoning rules vary widely by location so it is important to ensure compliance with all local rules.
The Risks of Investing in Residential Real Estate
For the reasons above, many view a residential rental property as a good introduction to the world of real estate investment. However, there are several risks that potential residential real estate investors should also be aware of:
1. Vacancy Risk
Because of the small number of tenants in a residential property, there is increased vacancy risk. For example, assume that one of the tenants in a duplex decides not to renew their lease. When this happens, the property’s occupancy falls from 100% to 50% overnight, which can have a significant impact on rental income.
2. Turn Cost
Residential leases tend to be short term – around 12 months – which means that tenants could be moving in and out frequently. Each time this happens, the property needs to be “turned” to prepare it for the incoming tenant. This means new paint, fresh carpet, minor repairs, and/or replacing appliances and the costs for these items can have a significant impact on overall profitability.
3. Maintenance & Repairs
Single family homes require regular maintenance. For example, the lawn needs to be mowed, the trees need to be trimmed, and the air handling systems need to be cleaned. Often the economics of a single family rental require this work to be completed by the property owner, which can be very time consuming.
Despite the risks, residential real estate can be a profitable investment if an investor is able to acquire the property at the right price. However, investors looking for additional scale and diversification may prefer commercial properties.
Commercial Real Estate Investment
Commercial real estate is any land or building used for business purposes with the intent to generate a profit through rental income and/or price appreciation. There are four widely recognized commercial property types: office, multifamily, industrial, and retail. Space in these properties is leased to businesses and the resulting rental income serves to generate a return on the owner’s investment.
At a high level, there are 3 common commercial real estate investing strategies:
- Yield: With a yield strategy, investors purchase an existing property that is at or near full occupancy and producing positive cash flow. Yield investors seek stability and this typically correlates with high prices, long term commercial leases, favorable lease terms, and high quality tenants. There is little chance for major price appreciation in a yield strategy.
- Value-Add: In a value-add investment, investors purchase a property at a discount to its intrinsic value and seek to add value to it through renovations, leasing, cost savings, and rental increases. Whatever the method the goal is to increase the property’s net operating income (NOI) and “force” the value to appreciate. Value-add investment returns come from a mix of cash flow and price appreciation.
- Distressed: A distressed investor seeks to purchase properties that are in bad shape. They could be in a poor location, in foreclosure, or in a state of disrepair. Following a significant capital investment and/or repositioning of the property, the distressed investor seeks to fill the property with new tenants. Once full, the investor could operate the property with positive cash flow or sell it for a profit. The bulk of a distressed property’s investment returns come from price appreciation.
Regardless of the chosen strategy, there are a number of significant commercial real estate benefits.
The Benefits of Investing in Commercial Real Estate
For some, a commercial real estate investment can be a bit intimidating due to lack of familiarity. However, those that choose a commercial investment over a residential one may benefit from the following:
1. “Forced” Appreciation
Commercial properties are valued based on the amount of Net Operating Income they produce. Because Net Operating Income is calculated as a property’s income, less expenses, the property owner can have a direct impact on its value. By pursuing strategies that seek to increase revenue (rent), reduce expenses, or both, an owner can increase Net Operating Income, thereby “forcing” the value of the property to rise. For example, we like to bring the property management function in-house after we make a purchase. Doing so immediately reduces the property management expense line item and increases Net Operating Income, which increases property value.
Investing in a commercial building helps to deliver scale for individual real estate investors. For example, if an individual has $100,000 to invest, perhaps they could buy one single family rental home. Or, they could use that same amount of money to purchase a fractional share of a multifamily apartment building with 300 units. The higher number of units helps to increase the amount of income earned.
3. Dispersion of Vacancy Risk
Most commercial properties have more than one tenant, which means there is less financial impact when one of them decides not to renew their lease. In the example above, occupancy for the residential duplex fell from 100% to 50% when one tenant moved out. In a 300 unit multifamily property, the decision of one tenant not to renew their lease is a relative non-issue. So, commercial properties allow real estate investors to distribute their vacancy risk over multiple units, making them less reliant on any one unit for income.
Unlike residential real estate, commercial investment strategies offer a variety of asset classes (retail, industrial, multifamily, and office) from which investors can choose. Each type of property has its own strengths and weaknesses and can be selected based on the economic outlook of each individual investor. For example, if one investor believes that a market is primed for a boom in business creation, they may prefer to invest in office space. Or, if another investor believes that a population boom will lead to increased demand for housing, they may choose to invest in a multifamily property.
Due to the scale and complexity of managing a commercial real estate asset, there are entire businesses built around managing the day to day functions on behalf of real estate investors. This allows investors to build a sizable investment portfolio with a relatively small amount of infrastructure.
6. Longer Lease Terms
A typical residential lease has a term of 12 months. A typical commercial lease has a term of 3-5 years or more. The longer term provides commercial investors with a steadier stream of income.
7. Qualified Tenants
Residential tenants are individuals. Commercial tenants are businesses, which generally have more financial resources than individuals. For commercial real estate investors, this means that there is less credit risk when dealing with business tenants. This is especially important in economic downturns.
8. Higher Returns
Given their scale, long leases, and forced appreciation, commercial properties tend to deliver higher, more consistent investment returns than residential ones.
The Risks of Commercial Real Estate Investment
While the benefits can be significant, investing in commercial real estate also comes with a number of risks that investors should be aware of. They include:
Commercial properties are expensive and likely out of reach for most individual real estate investors. But, that doesn’t mean that they aren’t accessible. Firms like ours pool investor capital and use it to purchase institutional-quality assets that investors likely could not afford on their own.
The pursuit of forced appreciation through increased Net Operating Income can take time. Often, the holding period for a commercial asset can stretch to 10 years. This increases the risk that an economic contraction could be experienced over the holding period.
Given their cost relative to residential properties, the pool of potential buyers for commercial real estate assets is much smaller than it is for a residential asset. It can take time to sell a property and return on investment could suffer as a result.
4. Less Stable During Economic Downturns
Certain commercial real estate property types – like office – are particularly vulnerable to economic downturns. For example, if a recession causes a small business to lose a high percentage of their sales, it increases the odds that they will be unable to make their rent payments in the future.
Commercial vs. Residential Real Estate Investing: Which is Better?
Given the comparisons above, it is tempting to ask which is the better asset class for real estate investment, commercial or residential? The truth is that one asset class isn’t objectively “better” than the other. There is a compelling case for both property types. Instead of focusing on “better,” we like to encourage investors to focus on which type is more suitable for an individual investor’s goals, risk tolerance, and time horizon.
For investors with a relatively small amount of investable capital, short time horizon, lower risk tolerance and/or desire for a more liquid asset, a residential real estate investment may be a better fit.
For investors with a longer-term time horizon, higher risk tolerance, and an ability to tie up capital for 5-10 years, commercial real estate might be the right option.
Investing In Both Commercial and Residential Real Estate
The prior section implies that an investor must choose between residential and commercial real estate investment. But, this isn’t the case. In fact, investing in both types increases portfolio diversification and gets the best of both asset classes.
The key point is that each real estate investor has a unique financial situation and their goals and objectives vary widely. If their goals and available capital are such that there is room for both property types, it can be a net positive.
Private Equity Real Estate Investments
Whether investing in residential or commercial real estate, there are two major hurdles often faced by individual investors.
The first is knowledge and experience. It takes a significant amount of time and expertise to develop the necessary knowledge of real estate markets and underwriting principles needed to identify suitable deals. And, once the deal is closed, it can be equally time consuming to manage the property on a day to day basis.
The second is access. It also takes a long time to build the industry relationships necessary to gain access to the best deals.
In both cases, individual investors with day jobs may find that it is easier to outsource much of this work to professional real estate firms. Doing so, frees up investor time to focus on the things that are most important to them while leaving the most technical aspects of the deal up to the professionals. In addition, it can also generate healthy streams of passive income and key tax benefits.
One such group of experts described above is private equity firms, like First National Realty Partners. By investing with private equity firms, individuals can gain fractional ownership of institutional quality real estate while avoiding the time commitment necessary to find, finance, and manage it. For many, this is an attractive value proposition.
Interested in Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you would like to learn more about our commercial real estate investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.