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Whether you’re new to real estate investing or have been investing for a while, you’ve probably asked yourself if commercial or residential real estate is a better investment. The truth is, neither option is better than the other—both have pros and cons that investors need to evaluate to determine which investment type is right for them.
Let’s break down commercial vs. residential real estate and the advantages and disadvantages of both to help inform your investment strategy.
Commercial Real Estate as an Investment
Commercial real estate is any property that has five or more units. Typical commercial real estate properties are multifamily, office, retail, industrial, and hotel buildings. These properties are leased to businesses instead of to individuals or families.
Advantages of investing in commercial real estate
- Triple net leases: In a triple net lease, the tenant agrees to pay real estate taxes, insurance, and maintenance, in addition to rent. Triple net leases are common in commercial leases and are beneficial to investors because they lower building costs and maintenance that landlords usually cover themselves.
- Longer lease terms: Commercial properties tend to have longer leases, ranging anywhere from three to five years, and even up to 10 years. This means less turnover on tenants and guaranteed rental income for longer periods.
- Steady income: Because commercial real estate locks in tenants for longer leases, the cash flow is often higher and more consistent for investors.
- Appreciation potential: Unlike residential real estate, commercial real estate appreciation is affected by the property’s revenue, which means investors could see an increase in property value quickly.
Risks and challenges of commercial real estate
- Higher initial investment: Commercial real estate is more difficult for investors to get into due to the higher initial investment on these kinds of properties.
- Strict zoning laws: Commercial properties are subject to more strict zoning ordinances, which dictate how properties should be structured, such as parking requirements and what type of businesses can lease space in the building.
- More volatile: During an economic downturn, businesses are more susceptible to struggling, which can leave commercial investors without tenants. This can make commercial real estate a riskier investment.
Residential Real Estate as an Investment
Residential real estate is property that includes all single-family homes or buildings that have four units or fewer. For example, condos, duplexes, triplexes, and quadruplexes are all considered residential real estate. These buildings are sold or rented to individuals and families as residences.
Advantages of investing in residential real estate
- Lower initial investment: Residential real estate has a lower price tag than commercial properties, which means investors can more easily save up for a down payment on a single-family home or duplex.
- Larger buyer and tenant pool: Residential real estate offers a wider net of potential buyers or tenants because housing is something people will always need. Tenants of commercial buildings tend to have more specific needs for their space, whereas most individuals and families are looking for similar features in a home.
- Less volatile: For similar reasons, the residential real estate market is a bit less volatile than the commercial side when it comes to market downturns. Housing will always be in demand, unlike businesses, which feel the effects of economic instability more acutely.
- Simpler financing: Compared to commercial real estate, residential has much more simple financing that makes it easier for investors to analyze. Residential loans generally have lower rates and longer terms, and are easier to qualify for than commercial loans.
Risks and challenges of residential real estate
- Less stable tenants: This is not always the case, but residential real estate tends to have less-stable tenants than commercial because the lease lengths are shorter. Businesses may stay at a commercial site for 10 years or more, while individuals and families tend to move more often when they’re renting.
- More responsibility: Residential real estate has fewer options for investors to come up with capital than with commercial real estate, which means investors often need to come up with the entire down payment themselves. Additionally, landlords are responsible for all operational costs, including property taxes, insurance, and maintenance, which can be avoided in some commercial real estate lease terms.
Factors to Consider When Choosing Which to Invest In
Investment goals and risk tolerance
Commercial real estate tends to be a riskier investment due to the significant amount of capital needed for a down payment, but greater risk can also mean greater returns. Commercial properties tend to appreciate and generate higher cash flow more than residential properties. However, the operating costs of a commercial property are much higher, and it’s more difficult to find a buyer for these types of properties.
Both commercial and residential real estate involve risk, but investors must evaluate each deal to determine if this risk is something they can handle and if the potential of higher returns is worth it.
Capital and financing options
While commercial real estate requires a higher investment, there are more options for financing, such as partnering with other investors, borrowing private money, or getting involved in a real estate investment trust (REIT). These options may make commercial real estate more accessible, since residential investors only have the option to partner with a family member on these investments.
On the other hand, commercial real estate loan interest rates tend to be higher, have shorter terms, and be more difficult to acquire because commercial real estate is considered a riskier investment. Lenders require investors to present a business plan that breaks down how things will be paid for, projected maintenance, and the property’s projected cash flow. These requirements may encourage investors to focus on residential real estate instead of commercial.
Location and market conditions
It’s important to do your research on your market’s conditions and the property location. Location and market can significantly affect prices and rents, and the costs may influence you to choose commercial over residential, or vice versa.
If businesses have been closing or moving out of office buildings, those are signs commercial real estate may be struggling in your area. On the flip side, if there are a lot of single-family homes and residential properties sitting vacant, that indicates the market may already have enough residential options.
Management and involvement level
Commercial and residential real estate investments require different levels of management that investors should take into account. Typically, commercial properties require more management, since they are larger buildings, and investors will often enlist the help of a property manager to maintain the property. Residential properties are generally less complex to manage, and investors can handle it themselves if they prefer to be more hands-on.
Exit strategies and long-term plans
In general, commercial property is considered a longer-term investment (five years or more), since these properties require more capital and it’s difficult to find buyers. If you’re afraid of getting tied into a longer commitment, residential real estate may be a better fit, since the buyer pool for these properties is larger.
Final Thoughts
The best real estate investment you can make is the one that works for your budget and time commitment while showing favorable returns.
Early investors will often start with residential real estate, due to the lower cost of entry, and then work their way up to commercial properties that have higher cash flow and steadier tenants. Residential real estate investments also generate returns faster than commercial investments, so investors can build up their wealth with residential properties and then dive into commercial real estate as the next step.
As with any investment, do your research on your market, financing options, and the type of properties available to make the decision that’s right for you.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
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