Are you interested in real estate investing but don’t know where to start? In this blog post, we will compare Residential vs. Commercial Real Estate Investing and help you decide which is right for you. Both types of investments have their pros and cons, but one may be a better fit for your personal goals and investment strategy. So, let’s get started!
Commercial properties typically generate more gross income with less effort. In most parts of the country, residential properties offer higher returns and do not necessitate a significant outlay of capital because there is no mortgage and tenants do not incur interest expenses.
Key Takeaways
- Real estate is regarded as a class of assets that should be incorporated into a well-diversified portfolio at least to some extent.
- The majority of states require the same license for commercial and residential real estate agents, and the use of each license is usually the same.
- The interest rates that are charged on loans for commercial real estate are typically higher than those that are charged on loans for residential real estate.
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How Do Residential and Commercial Investing Differ?
Generally speaking, the gross revenue that is generated by commercial properties can be increased with less effort. Because there is no mortgage and tenants are not responsible for any interest costs, residential properties offer better returns in most parts of the country. Additionally, they do not require a significant outlay of capital because there is no mortgage and tenants are not responsible for any interest costs.
Pros of investing in commercial real estate
Higher Returns
There’s no denying it: investing in commercial real estate can be an incredibly lucrative, long-term investment.
This is because commercial properties tend to appreciate over time, which will allow you to sell them at a profit and reinvest your money into another property. The more properties you have, the more money you’ll make when you decide to sell them.
Easier to Increase Property Value
One of the main benefits of this type of investment is that it’s easier to increase property value than residential real estate. This means that if you get a great deal on a commercial property, it will be easier for you to increase its value over time—and ultimately sell it for more than what you paid for it.
Tax benefits
You can deduct any interest that you have paid on a commercial mortgage, which is another advantage of the commercial real estate tax. If you have paid interest on a commercial mortgage, you are eligible for this deduction.
Higher Quality Tenants
Tenants who rent commercial real estate are typically more stable than residential tenants, since they tend to be larger companies with long-term plans. This means that you can expect higher occupancy rates and fewer vacancy periods, which means less time and money spent on advertising vacancies and attracting new commercial tenants.
Fewer Expenses as a landlord
When you own a residential property, there are a lot of additional expenses—including maintenance costs, utility bills, and mortgage payments—that come with owning it. When you’re dealing with commercial properties, however, those same expenses don’t apply (or at least not at the same rate).
That’s because there’s no need for things like lawn care or landscaping when you own a store or office building! All those costs go away once you’ve purchased the property because they’re someone else’s responsibility now (the tenant). This means that all your expenses will be limited to just maintaining what’s necessary (like replacing broken windows) and paying taxes on it each year too!
Forced Appreciation
A manager can “force” an increase in the value of a commercial real estate property because the value is determined by the amount of Net Operating Income the property generates. This can be accomplished through the management of expenses, value-added projects to increase income (like refurbishments), or a combination of the two.
Because Net Operating Income is determined by subtracting operating expenses from a property’s income, the owner of the property has direct influence over both the equation that determines Net Operating Income and the overall value of the property. An owner can increase their Net Operating Income and “force” the value of their property to rise by pursuing strategies that aim to either increase their income or decrease their expenses, or both. These strategies can be combined.
Longer Leases
The typical residential tenant commits to a lease for one year. The typical arrangement for a commercial tenant is to sign a lease for a longer period, which results in increased predictability for the stream of income generated by the property. This is especially helpful during times when the economy is in a state of distress (like the COVID-19 pandemic).
Cons of investing in commercial real estate
More Research and Money
The purchase of commercial real estate is typically only within the financial means of the most well-off investors and businesses. This is especially true of the commercial properties that are considered to be among the most desirable.
At this point, there are two potential dangers. To begin, the high cost of commercial real estate necessitates the expenditure of a sizeable amount of capital; however, this also means that there is the possibility of incurring a sizeable loss of capital.
Second, the high cost of commercial real estate can make it difficult for investors to diversify their portfolios because of the significant amount of capital that is required to buy one of these properties.
Competition From Large Retailers
This can be a problem because large retailers can take advantage of economies of scale that smaller companies cannot. This means that they can offer better deals on rent and other costs, which can make it difficult for smaller companies to compete.
More Zoning Laws
Zoning laws are one of the biggest cons of investing in commercial real estate. If you’re a commercial real estate investor, you know that zoning laws are important to understand. Zoning laws determine what type of business can be run from a specific property and what kind of uses are allowed on the property.
Finding Commercial Financing
Finding commercial financing can be a lengthy process, as lenders need to assess the risk involved with a particular investment. Additionally, commercial loans are typically larger than residential loans and require more in-depth analysis before being approved.
More Complicated to Analyze
One of the biggest reasons people don’t invest in commercial real estate is that it’s just more complicated to analyze than other types of investments.
Whether you’re buying a building or a piece of land, there are a lot more factors to consider than just how much it will cost and what kind of return you can get on the money you put into it.
The value of any particular property is dependent on so many factors—the location, whether or not there is any space available nearby for expansion, whether or not the neighborhood is desirable for businesses or residents—that it’s hard to predict what kind of return you’ll get from your investment.
More Volatile During Economic Downturns
It’s important to remember that investing in property is a long-term commitment. You can’t just sell it whenever you feel like it, and you can’t expect to see a return on your investment overnight. Because of this, many investors choose not to use real estate as an asset class when they’re trying to grow their wealth.
Pros of investing in residential real estate
Lower Barriers to Entry
The barrier to entry for residential real estate is much lower than it is for commercial real estate. You don’t have to purchase an entire property or building, just a single unit. This can be a good way to dip your toes into the world of investing without making a huge commitment right away.
Steady Demand
The demand for residential real estate is steady. As long as there are people who need a place to live, there will be a market for homes. Many investors choose to invest in this asset class because it provides a stable stream of income that isn’t dependent on the ups and downs of the market.
Earlier IRS Depreciation
It is not necessary to pay the total cost of a physical asset all at once when it is purchased because the cost can be spread out over its useful life.
For instance, a company spends $2,000 on a laptop with the expectation that it will be useful to them for the next five years. According to the regulations of the Internal Revenue Service, it could be depreciated by a total of $400 each year. This amount can be applied as a credit against revenue, which will help bring the annual tax bill for the company down. Properties that are rented out are subject to the same rules.
The costs of maintaining investment properties can be recovered through depreciation, which is then used as a tax deduction each year. The real estate, after some time, will start to deteriorate, and the depreciation deduction is, in essence, compensation for the “wear and tear” that the property endures over time. Depreciation is always considered a net loss on the real estate investment for taxation, regardless of whether or not there were any profits realized on the property.
The amount of the deduction that can be taken is dependent on the current market value of the asset being depreciated, as well as the length of time it will take to recover the value of the asset. The modified accelerated cost recovery system is the method of depreciation that is used the most frequently.
This method enables investors to deduct depreciation on a residential property or commercial real estate for 27.5 years or 39 years, respectively, depending on the type of property.
Tax benefits
By the provisions of the Tax Cuts and Jobs Act of 2017, a tax deduction that is beneficial to real estate investors, owners of small businesses, and self-employed professionals were established. In common parlance, this deduction is referred to as the pass-through tax deduction, but its official name is the Qualified Business Income (QBI) deduction.
According to the QBI, qualifying parties are eligible to receive a deduction of up to 20% of the qualified income they receive from pass-through business entities like partnerships, sole proprietorships, S-corporations, and limited liability companies (LLCs), such as qualified rental income.
Even though it can require a significant amount of work to bring in tenants and rental money regularly, real estate income received in such a manner is often classified as passive income by the Internal Revenue Service (IRS). This is the case even though it is often considered to be passive income.
As a consequence of this, you may be qualified for additional tax breaks and deductions depending on the kind of property you own and how it is managed, as this will determine how much money you can save.
Consistently perform during economic downturns
The residential real estate market is one of the few areas of the economy that consistently performs well during times of recession. While other markets may drop off in value and even become depressed, residential real estate tends to hold its own and even increase in value as investors seek safe places to put their money.
Larger Buyer Pool
One of the biggest pros of investing in residential real estate is the larger buyer pool. While commercial properties are often limited to businesses and other commercial entities, residential properties can be sold to anyone who meets the requirements of ownership.
Cons of investing in residential real estate
Less Cash Flow
One of the biggest cons of investing in residential real estate is that it provides less cash flow than commercial properties. Residential properties tend to have higher maintenance costs than commercial properties, which reduces the amount of money that can be put back into a property. While this may not seem like a big issue at first glance, over time it can add up and end up costing you more money than expected.
Property Value Depends on the Neighborhood
Another con of investing in residential real estate is that the value of a property depends on the neighborhood. If you buy a house in an area where the housing market is hot, then you may see your investment grow quickly; however, if you buy in an area with low demand or high crime rates, then it will be harder to sell the home and make a profit.
Shorter Term Tenants
Another con of investing in residential real estate is that the tenants are typically not long-term. In many cases, they will only stay for a few years or until they find their own place. This means that you won’t get to enjoy your home as much as if you were living there yourself.
Rent control laws
in some areas can also hurt your profits. While these laws are designed to help renters, they can also prevent landlords from raising the rent on their properties. This means that you may have a hard time getting back what you put into the property in the first place.
Harder to add value to the property
The biggest benefit of investing in residential real estate is that you can add value to the property over time. If you want to rent out a home, it will likely be worth less than what you paid for it. This means that if you want to sell it at some point in the future, you may not get all of your money back.
Are Commercial Loans Harder to Get than Residential Loans?
The interest rates that are charged on loans for commercial real estate are typically higher than those that are charged on loans for residential real estate. In most cases, they are between 0.5 and 1 percentage point higher than the prime rate for 30-year mortgages.
The exact type of loan, the property, and your financial profile all play a role in determining your interest rate, which can range anywhere from 3% to 20% right now. Commercial real estate loans typically have a shorter repayment term than residential real estate loans, which can result in a higher overall interest rate for the borrower.
In addition, just like with residential mortgages, there are closing costs associated with commercial real estate loans. These fees are typically between 3% and 5% of the total amount that was borrowed. When it comes to loans from the Small Business Administration (SBA), you may be required to pay a guaranty fee of up to 3.75 percent of the total amount borrowed.
Commercial vs Residential Real Estate Agents: What to Know
Types of Properties
There are many different types of properties, and real estate agents specialize in different ones. Residential agents, for example, focus on selling homes and apartments. Commercial real estate agents typically handle office buildings, warehouses, and other commercial properties. An expert in each field can help you get the best deal possible on your next home or office building.
Education and Training
Because the majority of states require the same license for commercial and residential real estate agents, the use of each license is usually the same. This means that commercial agents and residential agents hold unique licenses very rarely unless it is required by a law that is specific to the state in which they work.
Therefore, a real estate agent with a valid license is able to sell any kind of property, whether it be residential or commercial, in the majority of locations. Even though the majority of real estate agents stick with one type of property and specialize in a certain type of sales, it is still important to keep this in mind if you ever want to switch specializations within the real estate industry.
Past Clients
Past clients are one of the best ways to determine if a real estate agent is worth hiring. Asking for the names, contact information, and phone numbers of previous clients can help you get an idea of what kind of work they do and how well they perform it. The more past clients that you speak with, the more likely you are to find someone who fits your needs as well as your budget.
Work Schedules and Responsibilities
The time that a real estate agent can dedicate to you is also something that should be considered when hiring one. If you need someone who can work around your schedule and be available at any time, then make sure the agent has this ability before hiring them. This will help cut down on wasted time and missed opportunities for both parties involved.
What Is Passive Commercial Real Estate Investing?
A passive real estate investment does not require the investor to expend significant effort to maintain. There are several passive real estate investment possibilities, including real estate investment trusts (REITs), crowdfunding, remote ownership, and real estate funds.
Invest in the Real Estate That’s Best for You
The real estate market is constantly changing, and what’s best for you may not be the same as others. It all depends on your situation and goals, so make sure you do some research before jumping in. Once you have a better idea of what type of real estate investment is right for you, feel free to reach out to me today.
Residential vs. Commercial Real Estate Investing FAQs
Which Is Easier to Finance?
Mortgages for residential real estate are typically more accessible to the average investor. Using a government-assisted down payment loan program, such as VA or FHA, residential properties can be purchased with as little as a 3% down payment, depending on the purchaser’s creditworthiness and income history. This loan debt is repaid over some time in regular installments.
Which Delivers a Better Return on Investment?
Investments in commercial property offer higher rental yields than residential property. When investing in commercial property, investors can typically anticipate a return between 8 and 10%, whereas the return on residential property is between 2 and 4%.
Can Real Estate Agents Do Commercial and Residential?
Yes, a real estate agent with a valid license can sell any kind of property they choose, including residential and commercial real estate. You always have the option to sell commercial property in the future, even if you decide to focus on selling residential property in the beginning.
Is commercial real estate riskier than residential real estate?
Investing in residential real estate is typically considered to be a safer bet than investing in commercial real estate. As the proverb goes, “great risk brings great reward,” and in this instance, “great reward” can mean an average return of 12.7% annually, which is significantly higher than the average return of 8.8% that residential property generates over 15 years.
What type of commercial property is most profitable?
Properties that have a larger than average number of occupants are typically in a better position to generate a higher return on investment for their owners. Multifamily developments, student housing, office space, self-storage facilities, and mixed-use structures are some examples of the types of commercial real estate investors of properties that may fall under this category.
Conclusion
So, which is better for you-residential or commercial? The answer to this question will vary from person to person and property to property. That’s why it’s important to consult with a professional who can help assess your unique situation and give you tailored advice.
At the end of the day, real estate investing is a very personal decision. But we hope that this article has given you a good overview of the two most common types of real estate investments and armed you with enough information to make an informed decision.
If you have any questions or want more advice, please don’t hesitate to call me or schedule a free consultation online.
