One of the first decisions that aspiring real estate investors have to make is what asset class to invest in. At the highest level, the options can be broken down into two categories, residential real estate and commercial real estate investing. The risks and benefits of each are the subject of this article.
Residential Real Estate
Residential real estate is defined as a real estate asset with a “residential” purpose, meaning people live there. Residential properties consist of single family homes, duplexes, triplexes, and quadplexes. They 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 barriers to entry are low, financing is widely available at favorable interest rates, property management requirements are relatively low, maintenance costs tend to be minimal, cash flow is stable, and price appreciation can be significant in the best markets. But, these benefits also come with risk.
Potential risks of a residential investment include: high transaction costs (6% commission paid to real estate agents), it does not scale without adding significant complexity, leases are relatively short (12 months), and there is a credit risk associated with a potential tenant default. In addition, residential real estate investing is highly regulated in some states and property owners are required to comply with local laws pertaining to evictions and rental increases. Finally, residential properties are valued based on the prices paid for comparable properties in the same real estate market which means that investors have minimal control over price appreciation.
While residential investment can be lucrative, investors looking for additional scale and diversification may prefer commercial properties.
Commercial Real Estate Investment
A commercial building is one that is acquired with the intent to earn a profit through cash flow, price appreciation, or both. Commercial properties are rented to businesses (as opposed to individuals) and there are four widely recognized property types: office, multifamily, industrial, and retail. At a high level, there are also 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. They include: stable rental income, portfolio diversification, high scalability, property diversification, forced appreciation through value-add activities, reduced taxable income through depreciation, widely available debt financing, long term leases, and reduced credit risk through renting to commercial tenants instead of individuals.
But, commercial deals aren’t without risk either. They also have high transaction costs – 6% commissions are paid to a commercial real estate agent. In addition, they require a significant amount of time and expertise to manage, are significantly more expensive, and certain property types like retail can be particularly vulnerable to economic downturns.
Which is Better?
When comparing the two investment options, it is only natural to ask, “which is better?” The truth is that neither one is objectively better than the other, but one may be a better fit with an investor’s personal objectives.
For new investors with limited access to capital, limited operational knowledge, and a small amount of time to spend managing the investment, a residential real estate investment may be the better fit.
Experienced investors who are well capitalized, looking for portfolio diversification, and have significant operational expertise may find that commercial property is a good investment.
There are risks and benefits to both so it is important for each individual investor to complete their own due diligence on each opportunity and to deploy capital into investments that are a good fit for their risk tolerance, time horizon, and investment objectives.
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.
To learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
