| Comparing Commercial vs. Residential Real Estate Risks and Rewards | ||
|---|---|---|
| Factor | Commercial Real Estate | Residential Real Estate |
| Average Returns | Higher rental yields due to longer leases and business tenancies. Potential for significant property appreciation. | Lower rental yields but steady income from shorter leases. Consistent long-term appreciation. |
| Initial Investment | Higher due to property scale and location. | Lower, making it more accessible for individual investors. |
| Operational Costs | Higher, including maintenance, property management, and customization for tenants. | Relatively lower and more manageable. |
| Market Sensitivity | Higher sensitivity to economic cycles and business demand. | Less sensitive, with more stable demand. |
| Tenant Turnover | Lower turnover due to longer lease agreements. | Higher turnover with shorter lease terms. |
| Risk Profile | Higher risk, with potential for greater returns. | Lower risk, offering stable and consistent returns. |
| Accessibility for New Investors | Less accessible due to higher capital requirements and complex management. | More accessible, with lower capital requirements and simpler management. |
| Lease Structure | Net leases common (single, double, triple), transferring more expenses to tenants. | Gross leases are prevalent, with the landlord covering most expenses. |
Choosing Between Commercial and Residential
Whether to invest in commercial or residential real estate is a significant decision that hinges on your financial resources, investment goals, risk tolerance, and expertise.
Financial Resources and Initial Investment
Commercial real estate typically requires a higher initial investment compared with residential properties. This includes not just the purchase price but also potential renovations, legal fees, and a buffer for initial vacancy periods. Commercial assets can cost millions more upfront than typical residential rentals because of their scale and development expenses. Investors must assess their financial capability and access to capital.
Residential properties are more accessible to a broader range of investors, including those with limited capital, because of generally lower entry costs.
Investment Goals and Time Horizon
Commercial real estate might be more suitable if your objective is to generate a higher income in the short term given net leases and its potential for higher rental yields. Residential real estate can be a more attractive option, however, if you’re looking for long-term wealth accumulation with a steady income. It has the potential for consistent rental income and property value appreciation over time.
Risk Tolerance
Commercial real estate is usually more sensitive to economic cycles. It can offer higher potential returns but it also comes with higher risks such as longer vacancy periods and more significant impact from market downturns when businesses scale back and may close certain locations.
Residential real estate typically offers more stability, making it a relatively safer choice for investors with a lower risk tolerance. People need a place to live even during a recession. Your decision should align with how comfortable you are with potential income and property value fluctuations.
Level of Expertise and Management Requirements
Managing commercial properties requires more expertise and sophistication because of the complexities of commercial leases, tax implications, property management, and business tenants’ particular needs. Residential properties are generally easier to manage, especially for those who are new to real estate investing.
Fast Fact
It might be prudent to consider the services of a property management company if you lack experience in managing commercial properties. It comes at a cost but it can minimize future issues.
Market Research and Location
Both types of investments require thorough market research but the criteria differ. Understanding the local business environment, commercial property demand, and economic forecasts are crucial when investing in commercial real estate. Residential real estate investment decisions are more influenced by neighborhood quality, schools, local amenities, and overall housing market trends.
Liquidity Considerations
Commercial properties typically have a smaller pool of potential buyers than residential properties and this can affect liquidity. You may not have the ability to sell quickly for a fair price. This can be important if you anticipate that there might be a need for you to liquidate your investment quickly.
Tax Implications
Both types of investments offer tax benefits and have implications.
Commercial properties are typically depreciated over a longer period for tax purposes, usually 39 years in the United States. It’s 27.5 years for residential properties. This extended timeline can mean smaller annual tax deductions.
Capital gains tax applies when a commercial property is sold for a profit. Selling residential properties at a profit can incur capital gains taxes as well. Up to $250,000 of the gain or $500,000 for married couples can be exempted, however, if you owned the property for five years and it was used as a primary residence for at least two of those five years before the sale.
Residential properties typically have lower property tax rates than commercial properties but some jurisdictions offer tax incentives for commercial property investments to attract new businesses. They can include reduced rates or credits for developing in certain areas or for specific types of tenants.
It’s advisable to consult with a tax professional to understand how investing in commercial versus residential real estate will impact your tax situation.
Important
Commercial and residential real estate buyers can use the 1031 exchange provision that allows them to defer capital gains taxes by using the proceeds from the sale of a property to purchase another like-kind property.
Example of Commercial vs. Residential Investing
Jo is deciding whether to invest $1 million into a four-unit multifamily apartment building that’s a residential property or a small suburban office building that’s a commercial property. The apartment complex would generate around $300,000 in gross annual rent with expected expenses of 30%, resulting in $210,000 net operating income (NOI). The asset would be valued at about $4.20 million with an average apartment capitalization rate of about 5%.
The suburban office building has an asking price of $2 million. Its 10,000 square feet could command an average rent of $30 per square foot, providing $300,000 in potential gross annual rent. The expenses are about 50% for commercial properties so Jo expects $150,000 NOI. Commercial cap rates average about 7% so this indicates a valuation of $2.14 million.
Jo expects the apartments to appreciate at an average of 3% per year over five years in line with historical trends. Their initial $1 million investment would grow to $1.16 million. Adding in the estimated NOI of $1.05 million over the five years gives them a $2.21 million total return on investment.
The commercial building’s value is forecast to rise more quickly, averaging 5% yearly based on projected job growth and the demand for office space. Jo’s $2 million asset could grow to $2.55 million in five years. Returns would total $3.30 million with $750,000 total NOI projections over the five years.
Office buildings also have a higher vacancy risk than apartments in this smaller market, however. Jo’s NOI drops by $75,000 per year if vacancy rates spike to 25% in a weak economy. That creates almost $400,000 less in rental income over five years or about $2.90 million in total returns. Apartments might have only a 5% drop in occupancy with far less loss in rent. The more consistent residential income stream offsets slower appreciation.
Commercial promises higher returns but residential delivers lower risk and more stable occupancies. Investors must weigh these risk-return tradeoffs against their goals.
Tip
Don’t concentrate all your real estate investments in one region if possible. Different areas can experience unique economic and property market cycles so spreading your investments can mitigate location-specific risks.
Other Considerations
Every real estate investor approaches the market with different financial goals, timelines, experience levels, and personal risk comfort ranges. Determining investment priorities upfront enables tailored strategies that are best suited to an individual’s unique objectives and constraints.
One approach to capturing the benefits from each type of property is to diversify among residential and commercial properties. Diversification means spreading your investments across different types of properties and locations. This strategy reduces risk because different real estate segments often perform differently under the same economic conditions.
You can also diversify how you invest in real estate. Real estate investment trusts (REITs) own, manage, or lend money for real estate. You get shares in a trust with a portfolio of properties when you invest in a REIT. They offer greater liquidity and most are traded on the major stock exchanges. They must distribute at least 90% of their taxable income to shareholders.
Is Commercial or Residential Real Estate a Better Investment?
There is no “better” real estate investment. Commercial properties offer higher profit potential but they require heavy capital and expertise. Residential rentals serve as an accessible entry point with lower risks. Investors must evaluate options and strategies based on their situation and long-term goals.
What Are the Categories of Commercial Real Estate?
The main property types that fall under commercial real estate in addition to office, retail, and industrial spaces are hotels, restaurants, self-storage facilities, data centers, cellphone towers, housing for retired adults, student housing, medical offices, manufactured home communities, and multifamily apartment buildings with over four units. Each sub-sector has unique risk-return drivers for investors to research before investing.
What Types of Residential Properties Should a Beginning Real Estate Investor Target?
Beginning residential real estate investors generally do better starting with smaller multifamily properties of two to four units like duplexes, triplexes, and small apartment buildings. Each offers a certain degree of affordability, consistent cash flow, and rental demand with less intensive maintenance than large single-family rentals.
What Are the Differences Between Residential and Commercial REITs?
REITs expose investors to real estate assets without having to buy, manage, or finance properties directly. Their shares trade like stocks on exchanges, allowing ordinary investors to access real estate portfolios indirectly.
Residential REITs invest in rental housing like apartment buildings, single-family rental homes, student housing, and senior residences. They earn revenue primarily through rental income from the occupants.
Commercial REITs invest in properties that are leased to retail, office, industrial, and other business tenants. Revenue comes predominantly from business lease agreements.
Can I Invest in Both Commercial and Residential Real Estate?
Yes. Combining both commercial and residential investments enables real estate investors to build a diversified portfolio that takes advantage of the stability of residential properties along with the higher income potential of commercial real estate.
The Bottom Line
Deciding between commercial and residential real estate hinges on understanding their unique characteristics and how they align with your investment objectives. Commercial real estate offers higher earning potential but the substantial capital and management expertise required make it prohibitive for many investors. The stability and accessibility of residential rentals offer a more feasible starting point to gain experience and slowly expand into commercial properties over time.
Investors should carefully weigh their available resources and expertise against expected returns and risks when deciding between commercial and residential real estate investing.
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