Commercial Real Estate vs Residential Real Estate Investing

Both commercial and residential properties can provide real estate investors with steady income and tax benefits, making it essential to determine which will be your best bet. While commercial real estate properties can be lucrative, residential property is often the more profitable venture.
In this article, we'll discuss the benefits and drawbacks of commercial and residential real estate property to assist you in making this pivotal investment decision.  

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Commercial Real Estate

Commercial property is used by businesses, typically commercial tenants such as hotels, office buildings, retail, industrial, special purpose, and other businesses. Apartment buildings with five or more units fall under this category, too. 

Pros

Commercial real estate investors have a variety of reasons why they prefer this sector of rental properties, including greater stability and higher net operating income due to specialized lease agreements like modified gross net leases.

Greater Rental Income

Investing in commercial real estate often allows you to command higher rents for several reasons.

Firstly, you are more likely to have multiple tenants if you purchase a commercial building, such as a strip mall or office building. You can also charge more rent in the commercial sector because tenants of commercial properties tend to have predictable cash flow due to their own ventures.

The other reason is that you can often offload some of your operating expenses onto the tenants through options like triple net leases. A triple net lease means that the tenant will pay for things like real estate taxes, building insurance, and maintenance costs in addition to utilities and rent.

You may also seek absolute net leases, where the tenant is responsible for all costs, including major renovations. You may find this more in specialized structures like industrial properties, where there is one long-term tenant who will struggle to find comparable commercial properties.

The property owner will charge slightly lower rent, which is recouped by the reduced cost and hassle of managing those other expenses. This is common for a commercial lease but not applicable to residential tenants.

Low Tenant Turnover

Commercial leases tend to be longer than residential leases because small businesses don't want to move operations on a whim. They build their reputation on stability, and moving frequently may make them seem untrustworthy to their customer base.

In contrast, residential housing tends to have higher tenant turnover because tenants are not as attached to the property.

As such, commercial real estate investors may be able to lease commercial properties to the same tenants for years, even decades, which provides them with more predictable cash flow. 

Easier to Increase Value

Finally, commercial property owners often find it easier to make improvements to their real estate because of the higher and more consistent rent. Commercial real estate property value rises by an average of 1.3% per year. However, this can be much higher when the economy is doing well, and more businesses are moving to the region. 

Cons

While this paints a rosy picture of commercial real estate investing, there are some serious pitfalls to consider before seeking commercial real estate loans. Many of these are specific to this particular subset of real estate, making it all the more important to heed the warnings.

Property Management

Regardless of whether you're managing commercial or residential property, you will have to contend with some property management costs. However, commercial property tenants will not only generate more expensive problems, such as replacing multiple HVAC units at a time, but they also tend to be far more demanding than residential real estate tenants.

You will likely have to have a dedicated property manager for your commercial projects in order to satisfy tenants. As mentioned, it's possible to offload some of these through triple net leases. Still, your fellow business owners are more likely to negotiate terms in their favor than residential real estate tenants, and they may reject such offers.

Susceptible to Recession Volatility

While both residential and commercial property are somewhat subject to the whims of the market, commercial real estate is far more so. A small economic downturn can lead to your tenants going out of business, which leads to expensive vacancies.

You still have to pay property taxes, commercial loans, and maintenance costs, even if you don't have a strong cash flow. This can lead to serious financial difficulties for a commercial real estate property owner. 

Limited Exit Strategies

It's also more difficult to exit a commercial real estate venture than for residential real estate. Not only will there be fewer buyers, but other investors will take a scrutinizing eye to every factor of your business, from the prior rental history to the maintenance expenses, as they want to ensure that their own bottom line is protected.

Negotiations will take longer for commercial property, and there will be fewer bids to choose from. This is not to mention the issues of finding real estate agents who can represent you and the extensive paperwork.

A final issue is that as demographics change, commercial zoning laws may also shift, potentially leaving your real estate business in trouble. It will be even harder to escape a struggling commercial property venture if you can't find a seller due to restrictions. 

Loan Approval for Commercial Properties

If you've carefully investigated the benefits and drawbacks of commercial real estate, it's time to think about seeking a commercial loan.

Visio Lending offers DSCR loans, which are tailor-made for commercial real estate investing. These loans are based on the ratio of rental income to operating expenses rather than your personal financial circumstances.

When you seek a commercial real estate loan from us, we have a simplified loan approval process that gets you into commercial real estate investing much faster.

First, let's go over the basic qualifications. You'll need a 680 credit score, an LTV of no more than 75%, and six months cash reserves. This is the same regardless of whether you are applying for a residential or commercial property.

You will send over some basic paperwork, including business documentation, your ID, a voided check, and insurance contact details. We will then perform a property evaluation and identify both its property value and its income-generating potential, from which we will calculate the DSCR ratio.

If we find that the ratio is satisfactory, we'll approve you, at which time we'll identify the mortgage interest and the loan repayment schedule. From there, you'll close, and we will disperse the funds. 

Residential Real Estate

Residential real estate investors focus on places that the average consumer will live in or visit for leisure. This includes single-family homes, duplexes, triplexes, four-unit buildings, vacation homes, and condominiums. 

Pros

Residential real estate may not look as immediately lucrative as commercial real estate, but it has far more advantages thanks to its affordability, consistency, and easier property management. Let's investigate each factor that makes residential properties an advantageous deal in comparison to investing in commercial real estate. 

Lower Entry Barriers

The initial investment for residential real estate investing is usually lower. Commercial properties tend to be very pricey, and this often makes it very hard for those new to real estate investing to break into the game. Residential real estate may only require $20,000 upfront, while the down payment for commercial real estate can be double that or more.

Easier to Manage

Residential rentals are more straightforward, with less complicated infrastructure that will require maintenance. Additionally, residential buyers don't need specialized equipment or layouts; you can have several residential properties that are nearly identical, making it much easier to take care of basic repairs.

Property management costs are also lower if you have single-family homes or duplexes because they won't have as intricate of landscaping or as high of utility bills. 

Resilient to Recession

Everyone always needs residential real estate, while commercial properties may go vacant for years during a downturn. While you may be unable to raise residential property rents as high as you need when the economy suffers, you can also be assured that your units won't go empty.

In this way, residential real estate is much more resistant to recession than commercial property because it is a basic need, one that doesn't diminish during bad economic times. While you still rely on your tenants' financial status, they are more likely to stay and negotiate with you, even if they're struggling to pay the bills. 

Consistent Demand

Furthermore, residential properties are always in demand, unlike commercial buildings. While residential leases tend to be shorter, there is also a greater pool of applicants to choose from when one tenant eventually leaves.

This greatly diminishes the hardship of higher tenant turnover because you can be nearly guaranteed that as long as your rates are in line with the average market and your property is well maintained, you will have potential tenants willing to move in.

Cons

While residential real estate has many positives, there are also a few concerns that you must be aware of before deciding to apply for a loan. 

Harder to Find Qualified Tenants

Though there are more potential tenants, this also means there are more bad apples out there. A tenant in a commercial building, like an office space, has more incentive to care for the property because it is also their place of business, but residential tenants will have fewer qualms about potential damage.

This makes it all the more important to vet tenants very carefully yet respectfully. Things like references, credit checks, and deposits can show that you expect your property to be treated with care while also weeding out those tenants who may not have a strong rental history.

You will likely spend much more time running background checks and interviewing tenants than you would when handling commercial leases.

Difficulties With Eviction

With commercial properties, the eviction process is very straightforward, as commercial tenants have less legal protection. However, residential real estate requires more care and a strong understanding of local regulations.

You may face fines if you don't follow the eviction process, which, in some jurisdictions, can take a month or more. This is something you will have to investigate both when purchasing residential real estate and any time you have to evict a tenant to ensure that rules have not changed. 

Loan Approval for Residential Properties

If you're looking for rental loans or vacation rental loans, the process is similar to that for commercial properties. First, you'll have to meet our minimum qualifications: a 680 credit score, 75% LTV, 6 months cash reserves, and a minimum DSCR of 1.2.

You'll submit paperwork such as your identification, business documents, homeowner's association contact details, insurance information, and purchase contract to be assessed by our loan officers. We'll use fair market rents and market value to identify the Debt Service Coverage Ratio, which will be a major component of our decision-making process.

If we identify a DSCR above 1.2 and the residential property is rent-ready with minor renovations, we will approve the loan and disperse the funds. Our process is much faster than that for a conventional loan, and you can expect to be ready to close within less than a month, depending on our current wait times.

Why are residential investment properties considered more stable than commercial ones?

Real estate investing is a highly diverse field, and there are a variety of niches to choose from, whether that's direct investing or real estate investment trusts (REITs). Among them, though, residential real estate is considered one of the most stable options for a few reasons.

Residential property tends to build equity on a more even trajectory, as it is more immune to market shocks. You can expect a more steady stream of tenancy, as everyone will always need somewhere to live, whereas, with a commercial building, you may experience high vacancies during economic downturns.

With residential property, you have a variety of options available. For example, you can convert a single-family home to a vacation property if the current market trends suggest it's a good idea.

This allows you the flexibility to pivot when conditions change, building resiliency. This is nearly impossible for commercial properties, which are difficult to convert and exit from when necessary.

Finally, there are tax benefits, such as lower property taxes, as well as lower operating costs. You may not need a dedicated property manager, which is a must for commercial real estate, and you will have an easier time negotiating leases with tenants.

While commercial properties can be a good option for highly experienced investors, they are also riskier and more expensive. By contrast, residential real estate is an excellent choice for investors of all skill levels and means. 
 

Commercial vs. Residential Real Estate Investing Bottom Line

Both commercial and residential properties can be a good choice for the right investor, but commercial property is a specialized field that requires experience and a healthy safety net should things go awry. Residential real estate, on the other hand, has a lower barrier to entry, a greater market appeal, and more flexible options for customization and improvement.

While commercial spaces may have more long-term tenants, they also have a smaller pool of applicants to choose from, and they are much more vulnerable to poor market conditions than residential properties. Residential rentals also have tax benefits and lower operating costs that are not available for those buying office buildings or strip malls.

Regardless of which you choose to pursue, work with great real estate agents and choose a great commercial loan lender who can help you through your journey of real estate investing. Visio Lending is the premier DSCR loan company throughout the United States, thanks to our simplified process, competitive rates, and full service for lenders.

If you're ready to get started with any type of real estate, contact us to submit a bid and begin your rental real estate dream.