Should I Invest In Commercial Real Estate or Residential Real Estate?
Should I Invest In Commercial Real Estate or Residential Real Estate?
Updated on September 14, 2020
For individuals with available capital and a desire to invest in real estate, the question of what to invest in is a natural one. At the highest level, the answer to the question boils down to two options, Residential Real Estate or Commercial Real Estate?
Like any investment, there are benefits and risks to both options that must be fully understood before committing to one asset class or the other.
Residential Real Estate
Residential Real Estate is any property that is used for residential purposes like a single-family home or duplex. There is, however, some overlap between residential and commercial assets when it comes to multi-unit properties. Properties with less than five units, like a triplex or qued-plex, typically fall into the residential category while properties with more than five units fall into the commercial category.
Residential Real Estate Benefits
For individuals that choose to invest in residential real estate, they may find that it comes with a host of benefits:
Low Barriers to Entry: Residential properties tend to be less expensive than their commercial counterparts and financing is widely available under generally favorable terms. Combined, these allow an individual to acquire a property with a relatively small down payment.
Housing is a Primary Need: A safe, clean place to live is a primary concern for many. In times of economic distress, rental payments are one of the first bills to be paid, which provides for a relatively stable stream of income for the property owner.
Small Number of Tenants: The maximum number of tenants in a residential property is four (a quad-plex), which means that there are a relatively small number to manage on a monthly basis. In most cases, property management can be handled by the individual owner.
Liquidity: 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 in commercial properties.
Residential Real Estate Risks
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 investors should be aware of:
Vacancy Risk: Because of the small number of tenants in a residential property, the impact on rental income can be significant when a tenant chooses not to renew their lease. At the extreme end of the spectrum, a single family property is either 100% occupied or 0% occupied. If a tenant decides to leave, rental income can vanish overnight.
Turn Cost: Residential leases tend to be short term – around 12 months – which means that tenants may be moving in and out frequently. Each time this happens, the property needs to be “turned” to prepare it for the incoming tenant. Often, this means new paint, fresh carpet, minor repairs, and/or replacing appliances. Costs for these items add up and can have a significant impact on overall profitability.
Maintenance & Repairs: Single family homes require regular maintenance in the form of landscaping, tree-trimming, cleaning of air handling systems, and maintenance of plumbing systems. While the cost for regular maintenance is relatively minor, it can be incredibly expensive if a major system needs to be replaced all together. For example, a new roof can easily wipe out years of rental profits.
Despite the risks, residential real estate can be a profitable investment when the asset is acquired in a strong market at the right price.
Commercial Real Estate
Commercial Real Estate is defined as land or buildings that are used for business purposes with the intent to generate a profit through rental income and/or price appreciation. A classic example of a commercial property is an office building or retail center. Space in these properties is leased by other businesses and the rental income serves to generate a return on the owner’s investment.
Commercial Real Estate Benefits
For some, commercial real estate may be a bit intimidating due to lack of familiarity. However, those that choose to pursue this path will benefit from the following:
“Forced” Appreciation: Perhaps the biggest benefit of commercial real estate investment is the concept of “forced” appreciation. Unlike residential properties, which are valued based on sales comparables, commercial properties are valued 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 makes the property more valuable.
Scale: A commercial real estate investment helps to deliver scale for individual 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 and purchase a fractional share of multifamily property with 300 units. The higher number of units helps to magnify the scale of an individual investment.
Dispersion of Vacancy Risk: Most commercial properties have more than one tenant, which means that the decision of any one of them not to renew a lease is less impactful than a residential property. Using the same example above, an owner of one single family home would find their income reduced to $0 overnight if their tenant does not renew their lease. 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 investors to distribute their vacancy risk over multiple units, making them less reliant on any one unit for income.
Variety: Unlike residential real estate, commercial offers a variety of asset classes (retail, industrial, multifamily, and office) for investors to choose from. Each class 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.
Outsourcing: Due to the scale and complexity of managing a commercial real estate asset, there are entire businesses built around managing these functions on behalf of investors. Key tasks can be outsourced, allowing investors to build a sizable portfolio with a relatively small amount of infrastructure.
Risks of Commercial Real Estate Investment
Like residential, commercial real estate investment comes with a number of risks that investors should be aware of:
Cost: Commercial properties are expensive and likely out of reach for most individual investors. But, that doesn’t mean that they aren’t accessible. Firms like ours pool investor capital and use it to purchase an institutional-quality asset that investors likely could not afford on their own.
Time: 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, which increases the risk that an economic contraction could be experienced over the holding period.
Liquidity: Again, commercial properties are expensive and the pool of potential buyers for any one of them is much smaller than it is for a residential asset. It can take time to sell a property and the investment returns could suffer as a result.
Which is Better?
We don’t necessarily believe that one asset class is “better” than the other. Rather, one asset class may be 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.
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.
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