When deciding what type of property to invest in, the first decision to make is usually whether to buy commercial vs residential real estate. These two types of properties offer a wide range of earning potential. But, depending on what you’re looking for and what your finances are like, one option might be a better fit.
What’s the Difference Between Commercial vs Residential Real Estate?
A commercial real estate property is any property with five or more residential units, or a property that is leased to a business. Commercial buildings include apartment complexes, industrial spaces, hotels, retail spaces and office spaces.
A residential real estate property is any property that has between one and four residential units. This can include a single-family home, a townhome, a condo, a mobile home, or a multiplex building.
Commercial Real Estate Investing: Pros and Cons
Before deciding whether to invest in commercial or residential real estate, it’s important to weigh the advantages and disadvantages of each, and consider which option is best for your individual needs. Commercial investment properties certainly have their pros and cons.
Commercial real estate leases last much longer than residential leases, which is beneficial for a number of reasons. For starters, long leases ensure a steady cash flow for anywhere between three to twenty years, depending on the terms of your lease. Long leases, like single-tenant net leases, also mean you won’t be dealing with vacancies as much as you would with a residential property, in which leases typically last only one year.
Commercial tenants also typically use single, double or triple net leases, meaning they may pay for recurring costs such as insurance, utilities and taxes on your property. Net leases are common in commercial real estate.
With a commercial property, the cash flow and rate of return is often much higher because you have more space to rent out.
A single-family rental property may go for a higher monthly rent than a single apartment unit. Nonetheless, multi-unit and multi-family properties, like quadruplexes’ income, often add up to much more than that whole house.
More Qualified Tenants and Fewer Tenant Obligations
With residential rental properties, it’s sometimes a gamble to find tenants who will consistently pay the rent on time, not break the lease, and not inflict damage on the property. However, in the case of commercial properties, tenants are usually businesses, corporations or something similar, making them more likely to follow your rules and respect the space.
In addition, residential properties often have more laws and protections for tenants that you would have to deal with.
“The big advantage for commercial real estate over residential real estate is that you have a completely different class of tenants,” said Josh DeShong, a real estate investor and founder of the real estate investing marketplace, Trelly. “You don’t have the same kind of consumer protections that you would have in residential.”
Easier to Increase Property Value
A residential property’s value is determined by the value of other properties in the neighborhood and specific characteristics of the property, like number of bathrooms and bedrooms, for instance. However, the value of a commercial property is based on the revenue generated by the property. So, if a commercial property has a high cash flow, then the value of the property is higher. If the property owner finds the right tenant, then they could easily increase their property value much more quickly than with a residential property.
More Dependent on Economic Trends
In economic downturns like the COVID-19 pandemic, commercial properties are usually the first to be hit, as retailers and small businesses suffer the most.
More Research and Money
Commercial real estate investing requires more money and research than residential investing. Commercial deals are generally more complicated and take more time to evaluate. Investors also need a lot more upfront money to purchase a commercial property, rather than a single-family home, for example.
Competition From Large Retailers
As a whole, small business retail has not been performing well in the U.S. because of competition from online retailers and larger companies like Walmart or Target. As a result, there are many empty commercial spaces across the country, and it takes an average of six months to lease out a commercial space. This is another risk when it comes to commercial property investment, especially if the real estate market is down.
More Zoning Laws
Commercial properties also deal with more zoning laws than residential, and building permits are more complicated to obtain. This case is especially true for build-to-suit properties that require special signage, or large retail shopping centers with outparcels.
Residential Real Estate Investing: Pros and Cons
Residential properties, too, have a number of advantages and disadvantages, and it’s important to understand both before deciding to invest in anything.
More Consistent Returns in Economic Downturns
In economic downturns, residential properties perform more consistently than commercial properties. When the real estate market suffers, retailers usually feel the effects first, and small business owners suffer the most. However, no matter what the market, people always need a place to live, so residential properties are not hit as hard.
Lower Barriers to Entry
As a whole, residential real estate investing is easier to get started with because it’s less complicated, and most people understand the landlord/tenant relationship when it comes to residential properties. Residential property investing is also more affordable than commercial.
“It’s much easier to find tenants for residential than it is commercial,” DeShong said.
There is usually steady demand for residential rentals across the U.S. because, as mentioned above, people always need a place to live. Millennials, especially, are renting homes much longer before buying. Finding a renter is usually easy for a residential space, and it takes less time than it would for a commercial space.
Earlier IRS Depreciation
IRS depreciation is the “recovery of the cost of the property over a number of years.” After a set number of years, the IRS allows you to deduct part of the cost of your property every year until you fully recover its cost.
With residential properties, the IRS allows you to depreciate the cost after 27.5 years. But, with commercial properties, you need to wait 39 years. Residential properties also offer “bonus depreciation.”
With residential properties’ short-term leases, tenant turnover can be frequent. Even though it’s easier to find a tenant for a residential property than a commercial property, they don’t always stay long, creating more work for the property owner to find more.
DeShong noted, “You might have a 5-, 10- or 15-year tenant in the commercial space, and that gives it a huge advantage.”
Less Cash Flow
Residential properties yield less cash flow than a successful commercial property, so the rate of return on your investment doesn’t have the potential to be as high as that of a commercial property investment.
Property Value Depends on the Neighborhood
Your property value depends on the neighborhood and comparable properties, making it more difficult to increase the property value in an undesirable neighborhood. If the neighborhood changes or becomes less desirable for reasons outside of your control, then your residential property value will go down.
Are Commercial Loans Harder to Get than Residential Loans?
As a whole, commercial loans are “much more difficult” to get than residential loans, DeShong said. “Whenever you get a commercial loan, you have to show you have some kind of history.”
Banks like to see that investors know what they’re doing, and that they have experience in real estate — specifically commercial real estate.
Commercial loans “require quite a lot of hoops that you need to jump through,” DeShong said, “whereas if you’re a residential investor, and you want to buy a house, you could just get a Fannie Mae 30-year fixed rate mortgage, just like you would on a purchase loan.”
Commercial real estate private equity loans tend to be more flexibile than traditional mortgages, but may come with higher interest rates that affect your cap rate.
Commercial vs Residential Real Estate Agents: What to Know
There are a few key differences between commercial and residential real estate agents that are important to know in order to decide which type of investment is best for you.
Types of Properties
Commercial and residential real estate agents work in two very different property areas. While residential agents only work with residential rentals, a commercial agent deals with many more types of spaces, so they need the proper knowledge about those spaces to understand the real estate processes.
Education and Training
Commercial and residential real estate agents go through a different education and training process. Both types of agents need the same education and training to obtain a real estate license, but a commercial real estate agent should also have a college degree in either business or finance because commercial real estate involves more complex financial concepts.
The two types of real estate agents also deal with different types of clients. As a whole, residential properties are easier to sell, so residential real estate agents will have an easier time searching for tenants than commercial real estate agents.
Commercial real estate agents have a higher earning potential than residential real estate agents because the cost of commercial properties is higher, giving the agent a higher commission.
Work Schedules and Responsibilities
Commercial and real estate agents also have a differing work life. Residential agents often have to work evenings and weekends because that’s when their clients are available to look at homes. However, commercial real estate agents work a 9 to 5 schedule.
The workload for commercial real estate agents is also heavier, simply because of the complex nature of commercial real estate deals. Commercial agents have to do more research and be more aware of economic and market trends to secure the best deal possible for their clients.
What Is Passive Commercial Real Estate Investing?
Passive commercial real estate investing is when an individual invests in a property as a limited partner. In a real estate limited partnership (RELP), the limited partner can invest their funds with another investor or company. In RELPs, the limited partner (LP) passively owns a share in the property, and the general partner is responsible for the business.
Commercial vs Residential Real Estate FAQs
Is commercial real estate riskier than residential real estate?
While commercial real estate has more earning potential than residential, it is also much riskier. DeShong noted, “From my personal perspective, I believe residential is the least risky of the two asset classes.”
Is commercial property a better investment than residential?
The answer to this question really depends on what you’re looking for, and what amount of risk you’re willing to undertake.
Invest in the Real Estate That’s Best for You
Knowing the differences between commercial and residential real estate, as well as the pros and cons of both, will certainly help you make better real estate investment decisions. In the end, though, everyone’s goals and finances are different. Be sure to know exactly what you want and what you’re able to manage before making any investment decisions.