Commercial real estate investing vs residential real estate investing

What’s the secret to making money from property investments? Should you invest in commercial or residential property?

These are not easy questions to answer as each comes with advantages and challenges.

Real estate has been a popular and lucrative investment vehicle for many years, with good reason. Since the fifties, house prices have climbed steadily, with the exception of the 2008 recession and the pandemic when prices dropped temporarily.

So far, home prices have recovered from the pandemic, but experts warn that the long-term effects cannot be determined yet.

Commercial real estate and residential real estate are the two primary categories of real estate property.

Distinguishing between residential and commercial properties

Residential real estate comprises single-family homes and one to four-unit rental residences. Residential properties are buildings meant for people to live in, not for running a business or as a manufacturing space.

Commercial properties, on the other hand, include apartment buildings, retail properties, office buildings, industrial buildings, warehouses, hotels, malls, and multifamily housing (five units or more),

Differences between holding residential and commercial properties

An obvious difference is the type of tenant. Residential properties are leased to families and individuals, while commercial properties are leased to businesses.

It is easier to get into the residential real estate market as a loan for residential real estate is easier to get than a commercial real estate loan.

These loans are easier to obtain because the residential real estate market is not considered as risky as commercial properties.

While commercial real estate investment is riskier, the potential rewards are also higher.

Commercial property offers a wider range of income possibilities, including real estate investment trusts, real estate investment groups, real estate limited partnerships, and real estate mutual funds, in addition to rental income. Residential properties offer other possibilities, including flipping houses, contract flipping, vacation rentals, fixer uppers and more.

Investing in residential properties is simpler and less stressful. Landlords only have to deal with a single tenant and rental contracts are less complicated. If the tenant vacates the property, it’s relatively easy to replace the tenant. In the case of a commercial property, it may take a while before a suitable tenant can be found.

Benefits of residential real estate investing

  • Cost of entry: Commercial properties are expensive. The average person doesn’t have the finances to invest in commercial property. Obtaining a loan is also more than the average person can afford. It might be better to start out with a few residential properties, and once income has been generated and experience obtained, only then start looking at commercial property.
  • Tenant turnover: Under normal circumstances, tenant turnover is not a major issue for residential real estate investors. If one tenant dies or gives up the rental property, it’s one tenant that has to be replaced. With commercial properties, especially in uncertain times, it can be difficult to keep tenants long-term. With residential properties, it’s possible to find people committed to long-term renting, which means the landowner won’t need to keep looking for new tenants from time to time.
  • Less restrictive zoning laws: When buying or building a commercial or industrial building, the zoning laws are very strict. City authorities don’t want warehouses and factories in suburbs where they can pose a danger to people who live there. Residential buildings come with fewer restrictions and the zoning is usually clear and established.
  • More opportunities for business: There are many more people looking for a place to live than there are people looking for a place to rent for a business. Additionally, in the wake of the pandemic, increasing companies have gone online and given up the commercial properties they needed for their business as remote work has become commonplace. The high demand for commercial real estate has dropped, while people still need to live somewhere.
  • More resistant to economic decline: While both the residential and commercial property markets suffer in an economic downturn, the need for somewhere to stay persists. At the same time, businesses may go under and be unable to keep up rental payments. In difficult economic times it may be challenging for commercial property investors to find long-term tenants.

Benefits of commercial real estate investing

  • Unique earning potential: One of the biggest differences between residential and commercial real estate is how property value can influence income. Commercial property values are directly related to how much revenue the business generates. So, the higher the cash flow, the higher the property value will be. A successful business that generates a lot of cash will increase the value of the property for the investors.
  • Higher returns: Compared to residential properties, commercial property investment is more lucrative. According to Investopedia, the annual return of the S&P 500 Index has averaged 10% over the past two decades. The real estate sector has matched this performance, even with the dramatic negative impacts of the 2008 financial crisis and the 2020 COVID19 pandemic. In fact the real estate sector has slightly outperformed the S&P 500 Index, with average annualized returns of 10.3% and 9.6%, respectively.
  • Qualified Tenants: For the most part, business owners face the public and have an obligation to look professional. For this reason, commercial tenants can be more reliable and more apt to look after the property than private tenants who can hide many sins behind closed gates and closed doors.
  • Benefit from triple net leases: Triple net leases are very valuable for commercial real estate investors. A triple net lease is an agreement whereby the tenant or lessee undertakes to pay all the expenses of the property, including real estate taxes, building insurance, and maintenance in addition to paying the rent and utilities. This is a great benefit for investors who stand to make even bigger profits.
  • Long-term tenants: Although this is not always the case, commercial leases tend to be longer compared to residential properties. Private tenants can also rent a property for many years, but it’s more common for commercial properties to be let for multiple years, which makes commercial property a lucrative and stable investment.

Holding costs

Holding costs, applicable to both buy-and-hold and fix-and-flip properties can be the hidden downfall of an investor because these costs add up quickly. Holding costs are the expenses a real estate investor has to pay while owning a property. Before investing in a property, an investor must be aware of these costs and be able to pay them otherwise the property investment will be a failure. These costs include:

  • Mortgage repayments
  • Property management fees
  • Property taxes
  • Strata fees
  • Insurance
  • Utilities
  • Trash collection

It’s important to consider the ongoing costs of owning a property. If this is ignored, the investor might have to sell before making any money on the property.

How to work out real estate return on investment

Different formula are used to calculate the average real estate return on investment, in other words, how profitable the investment is likely to be. Many factors come into play with this calculation, such as the rental income, rental expenses, and the price or value of the property.

Three methods can be used to calculate the return on investment, including:

  1. Basic formula for ROI calculation
  2. Cash on Cash Return
  3. Cap Rate

ROI calculation

Here is the formula:

  ROI =Annual Rental Income – Annual Rental Expenses  
Property Price
  X 100%

The real estate return on investment formula in practice:

A small shopping center worth $750,000, brings in a monthly income of $7,500. The rental expenses for the year are $5,000. The return on real estate investment is calculated as follows.

ROI = [($7,500 x 12 months – $5,000) ÷ $750,000] x 100% = 11.33%

This example works out to an above average return on investment. Normally, investors consider an average of 8% as a good ROI.

Experts note

Property investment experts point out that when calculating ROI, investors must keep in mind that there is one factor that rules this calculation and that’s location. Ultimately, where the property is situated will have the biggest effect on the investment value of the property. A property in Denver won’t yield the same return as a property in San Francisco. Investors that take the location into account will arrive at a more realistic and accurate estimate of the possible ROI.

Strategies for creating long term wealth with property investments

1.Residential Real Estate Investment

Residential real estate is the most popular investment type in the property investment sector and it comes with a wide range of option, apart from purchasing a property to lease it to someone to live in. The options include:

  • A home for rent to a family – long-term residential rentals is one of the most common methods for making money in real estate.
  • A home for renting out rooms to different people
  • Condominiums
  • Townhomes
  • Co-ops
  • Apartments
  • Vacation rentals
  • Flipping
  • Micro-flipping
  • Granny flats, basements, and sheds turned into dwellings
  • Fixer-uppers

All of these options offer possibilities to earn income from property. Let’s look at some of them in more detail.

Home flipping

Flipping is a popular option with a real possibility for making good money. If you choose your property well and know what it costs to renovate a run-down home, it’s possible to turn a profit on flipping homes. With labor costs at a premium and the cost of materials rising, flipping is no longer as profitable as in the past, but when the right property shows up, it’s not an opportunity to be missed, especially if you have the contacts, skills, and experience to get the job done.

Contract flipping

With contract flipping, you don’t actually buy a property. You find a distressed property and an eager buyer and put the seller and buyer in contact with each other. As the contact person, you enter into an agreement with the seller for another person to buy the property. Vacant homes or owners who are behind on their mortgages are ideal for contract flipping.

Vacation rentals

Vacation rentals can provide a lucrative income if the property is in a popular tourist destination, with a high demand for short-term rentals.

2.Commercial real estate investment

For those who can afford to invest in commercial real estate, there are a range of investment options:

Office real estate investment

Office real estate investment comprises renting out office space that to a company for an extended period. These leases are often long-term, so a dependable tenant can mean a worry-free investment.

Retail real estate investment

This comprises renting out pace to a retailer in a shopping mall or a small shopping center or a single space for a restaurant on the main street. Again, with a dependable tenant and a long-term lease, this can be a reliable income stream.

Even small towns have developments in shops, cafes, and restaurants.

Industrial real estate investment

Industrial real estate comprise buildings and other structures for industrial use like warehousing, manufacturing, etc. Industrial properties tend to be more affordable than residential, office, or retail properties because they are mainly open spaces with access to power and water and not much more.

Industrial real estate investment involve little operating and management costs. However, investors must ensure that the property and its operations don’t affect nearby residents

REITs (Real Estate Investment Trusts)

REITs, or real estate investment trusts, is a way for individual investors to earn income from commercial properties without having to buy or manage the properties themselves. REITs

The real estate is owned and operated by the REIT which the individual joins as a private partner. All partners earn income from the properties the REIT manages. Real estate investment trusts tend to outperform the market, resulting in high ROI. Individuals can invest in different REITs, including residential, mortgage, retail, office, and healthcare REITs.

The bottom line: which investments gives the best return on investment?

There is no simple answer to this question. It would seem that commercial property investment is more lucrative than residential property investment. However, this option is not open to everybody who want to build long-term wealth. For commercial property investment you must already have considerable liquid assets available to allocate to property investment.

In addition, the rate of return will depend on the type of rental property, its location and the reliability of the tenant(s).

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