Real estate is an investment worth considering. It diversifies a portfolio and can offer attractive income and appreciation. One way to invest is through residential real estate, where a person buys homes and rents them to tenants. Another is commercial real estate or CRE. This includes office space, shopping centers, industrial buildings, hotels, and apartment buildings. Residential real estate leases to families and individuals, while CRE leases to businesses.
So which is a better investment? Well, both have merit, but the proper choice depends on the goals and the characteristics of the individual investor. Read on to learn about the differences between residential and commercial real estate investment.
Risk Tolerance: Commercial Real Estate Is High-Risk, High-Reward
In general, commercial real estate offers greater risk and higher rewards. There are a few reasons for this.
Commercial real estate is more susceptible to downturns in the economy. When the economy drops, businesses fail, stores close, and fewer offices are occupied. Consequently, commercial property revenue drops. Even in good times, small business failure is common. Residential real estate investments are a little more stable since people always need a place to live. Tenants will generally try to meet the rent on their homes even if other bills go unpaid.
Also, it's easier to own more properties and spread risk with residential real estate. A residential landlord with several homes is more ready to deal with a vacancy in one. If that investor owns only one commercial property, the loss of the main tenant could put them in a bind.
Because of the increased risk, commercial real estate investors demand a higher return, and they get it. Annual returns of 10–15% are not uncommon. Furthermore, if a CRE investment becomes unsatisfactory, it can be harder to liquidate than to sell a home.
Investment Time Frame: Commercial Real Estate Requires Long-Term Commitment
Generally, the most successful CRE investors are those who are in it for the long haul. It takes a commitment of time and money to purchase and lease a commercial property, and it can be difficult and expensive to get out of the commitment.
Once a commercial property is occupied, it usually provides a reliable income stream for many years. Most residential leases are for 6 to 12 months, while commercial leases are often as long as 5 to 10 years. This means CRE has less turnover, less vacancy, and more cash coming in predictably and consistently.
Some short-term strategies often work well in residential real estate. For example, there are "flippers" who buy a home and improve it before selling. These handy homeowners buy where the property is appreciating and resell for a profit after a few years. These methods rarely pay off in commercial real estate.
Degree of Control: Residential Real Estate Is More Hands-On
For the hands-on property owner who likes a high degree of control, residential investment is the choice that offers that. A landlord homeowner with the right skill set can take care of all maintenance and repairs and deal with any problems that renters might come up with.
Commercial real estate offers more complexity with factors such as maintenance and janitorial contracts, liability insurance, and the care of a large building. Most owners hire professionals to take care of these things. Once the arrangement is up and running, CRE can offer more of a hands-off opportunity to earn passive income.
The tenants and the attention they need differ between the property types. While it's not without exception, commercial renters tend to be more respectful of the property and the rules. This is especially true in the retail and hospitality industries, where the tenants have a business stake in keeping the premises clean and attractive.
Budget and Financial Stability: Commerical Real Estate Costs More Than Residential
It takes more money and more preparation to get into commercial real estate investment than residential investments. Properties are more expensive, lenders regard mortgages as riskier, interest rates are higher, and qualifications are more stringent. Commercial loans usually require a higher credit score.
A lender can determine the value of a residential property with a relatively simple appraisal and a down payment as low as 5%. Commercial property lenders want to see more documentation to determine the value, which is based on the cash flow it can generate more than the location or the sale price of comparable properties. Most lenders require a business plan. They will want to see proof of cash flow. They'll need to know who will pay the utilities. They will ask what maintenance will be needed over time and what the plan is for seeing that.
The CRE investor needs to establish a contingency fund. The business plan needs to have cash available for short-term and long-term maintenance, both planned and unexpected. The investor must have money available and supplement it with a portion of the rent over time.
Tolerance of Complexity: Commercial Real Estate Requires More Experience
Anyone who owns the home they live in has a good start on owning a home as a landlord. Home prices and rental rates in a neighborhood indicate whether a residential property is a good investment.
With CRE, there's more to analyze before pulling the trigger on a deal. A commercial investor needs to be an educated investor. They need to understand financial statements, tax returns, property surveys, and more involved property inspections. They must understand the local supply and demand of whatever type of commercial property they're buying. They have to know how zoning ordinances dictate what they can and can't do with the property. They must recognize when to go to lawyers and other experts for specialized advice.
Is Commercial or Residential Better? It Depends on the Investor
There are typically greater monetary rewards available for the commercial real estate investor. There's also more risk as well as more complexity and need for education. CRE is generally a bigger commitment and a longer-term one. What resources do you have in terms of time and money, and how much risk are you comfortable with? The answers to these questions will help to decide which path is right for you.
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