Real estate investment is a trustworthy way to generate consistent income and attain financial growth. Before making any investment decisions in real estate, it is crucial to understand the two categories within this field. If you're considering investing in real estate, weighing the advantages and disadvantages of commercial and residential properties is essential.
Commercial real estate allows business practices, and residential real estate is used for housing. Commercial and residential real estate are good investments, provide tax benefits, and have a specific loan approval process. Commercial and residential real estate requires proper management.
Before investing in real estate, it's essential to consider various factors such as loan approval, tenant turnover, and the level of management required to ensure a successful investment. Real estate is profitable if properly managed and provides many great tax benefits. It's essential to carefully explore all the variables if you're considering investing in real estate.
Residential Real Estate: What Is It?
Residential real estate is property specifically where someone lives. The owner occupies residential real estate or is rented to a tenant. Residential properties with more than 4 units, student housing, and hotels do not fall under residential real estate but are categorized as commercial real estate.
Below are examples of residential real estate:
- Single-family homes
- Cooperatives (co-ops)
- Duplexes
- Condominiums
- Fourplexes
- Mobile homes
- Townhomes
- Triplexes
Some types of residential property are classified as "Mixed Property Use," which mixes commercial and residential uses. A home is deemed a mixed property if it has an apartment on the top floor and a shop on the ground floor. Although it is one building, each portion is individually identified as commercial and residential.
Commercial Real Estate: What Is It?
Commercial real estate pertains to properties used exclusively for business purposes. Generally, commercial real estate is leased to tenants to generate income and provide business activities ranging from shopping centers to stores. Individuals and investors benefit financially from commercial real estate through buying, upgrading, and selling it or leasing it to tenants.
Below are examples of commercial real estate:
- Office
- Retail (shops)
- Industrial (factories and workshops)
- Warehouse (storage buildings)
- Hospitality (holiday accommodation, restaurants, healthcare facilities, etc.)
Commercial real estate has another category called Special Use Properties. These special commercial properties include:
- Student Housing
- Casinos
- Resorts
- Sports stadiums
- Government buildings
- Religious facilities
Huge differences can exist even within the subclasses of residential and commercial real estate. For example industrial real estate will have completely different management needs and return expectations than retail.
Commercial vs. Residential Real Estate: Property Management
Although investing in real estate might be smart, several potential challenges and complexities exist. Properties require owners to be hands-on and manage the property and its tenants. Commercial properties cost more and are harder to manage than residential properties. If you want to invest in property, consider its manageability.
Residential Real Estate
Residential properties are easy to manage, especially if you only have one property. Dealing with a single tenant does not need a property manager, and the owner can handle everything themself. With that said, having more than one residential property can be difficult, and an owner may need to acquire the assistance of a property manager.
Another factor to consider is managing a residential property is more than just collecting the rent. Properties must be maintained to ensure the tenants are happy and avoid value reduction. Regularly inspecting the property is essential and will require additional money to be spent when repairs are needed.
Commercial Real Estate
Managing a commercial property takes dedication and a hands-on approach. Commercial properties are let to businesses and require that everything runs smoothly to avoid being held liable for income lost by the business owner. Another factor that makes commercial properties hard to manage is that you may deal with multiple units and, thus, more tenants.
Managing a commercial property on your own can be a daunting task. Hiring a property manager or a property managing company is recommended to ensure everything runs efficiently. Poor management of a commercial property will lead to loss of income and, if not properly maintained, will reduce its value.
It’s important to understand what your objectives are to determine the right sub asset class. Single family residential may be ideal if you want to maximize return on your sweat equity where you can effectively manage several rentals yourself. If you want to scale and run a business with employees larger multifamily facilities that employee staff on site may be the best option. If you want relatively hands off, but with lower return expectations and cap rates, industrial may be your best investment.
Commercial vs. Residential Real Estate: Tax Benefits
Investing in property has various benefits. The tax benefits from owning a residential or commercial property are one of the biggest reasons buying property is so popular. Investors can lose a significant portion of their profits to taxes. However, real estate owners can take advantage of various tax benefits. Here are some examples.
Residential Real Estate
The residential property provides various tax benefits, and in the long run, an owner can maintain and improve on his/her investment without seeing their profits disappearing. Here are some tax deductions that residential real estate owners with tenants can enjoy.
- Mortgage interest
- Repairs
- Rental income
- Property management costs
- Improvements
- Depreciation
Commercial Real Estate
Like residential property, commercial real estate has tax-deductible benefits for better growth and profitability. Commercial owners can deduct the following:
- Repairs costs
- Property management costs
- Rental income
- Depreciation
- Mortgage interest
Both real estate types have the same common benefits, but properties that have room for investment in improvements and subsequent earnings increases stand to benefit the most in savings from taxes.
Commercial vs. Residential Real Estate: Tenant Turnover
Investing in real estate is tricky, and finding a good and reliable tenant can be daunting, especially with residential property. Leasing property requires the owner or manager to carefully vet the tenant to ensure that the property is well cared for and that the rent is secure for the lease period. The tenant turnover varies between residential and commercial properties.
Residential Real Estate
Residential property has a larger tenant turnover due to shorter lease periods. Leases for residential properties vary between 12 and 24 months, with some going month to month for an undisclosed end date. Short residential leases often result in tenants neglecting the property, causing owners to terminate the lease and search for new tenants.
Homeowners may opt for shorter lease terms to assess tenants' reliability and property care before considering a lease extension. Residential tenants are less prone to care for the property than commercial property tenants, leading to early evictions and a larger tenant turnover.
Commercial Real Estate
Commercial real estate has a longer tenant turnover than residential real estate. Generally, commercial property leases are ten years and longer, and an in-depth vetting process ensures the owners' peace of mind. Commercial property tenants run a business from the property that reflects their professionalism and is inclined to care better for the property.
Because commercial property leases span over many years, contractual agreements include an escalation clause. The lease contract may include a clause that requires the tenant to share the increases in the building's costs Like:
- Operating expenses
- Real estate taxes
- Yearly rental increase
- Additional property insurance, etc.
Commercial vs. Residential Real Estate: Loan Approval
Finding a good investment is hard and needs careful consideration. Investing in commercial or residential property is good, but knowing the differences and investment potential is essential. Here are their basic loan approval differences to help you make a better-informed decision.
Residential Real Estate
A residential mortgage is easier to obtain for the average investor. Government programs like the FHA and VA allow those who want to buy a residence to do so with a 3% fixed rate down payment of the purchase price. I must mention that low downpayment percentages, such as 3%, are subject to a good credit score and income history of the buyer.
Payment plans for residential buyers vary, and most buyers favor the 30-year plan, although buyers can opt for shorter payment plans. The longer your payment plan, the smaller the installment, but the higher the interest; the shorter the payment plan, the lower the interest.
Commercial Real Estate
Compared to buying a residence, getting a loan for commercial real estate is more complicated to obtain. The purchaser must possess a favorable credit score and a positive income history to qualify for a commercial real estate loan. However, these factors only significantly influence the loan approval procedure.
Due to elements like the property's net operating revenue, location, and performance expectations, being accepted for a commercial real estate loan might be difficult. These factors are considered before a commercial loan is approved because it is a higher risk. Loan payment plans range between five and twenty years to reduce the risk, much shorter than a residential loan payment option.
Generally, commercial loans have a higher interest rate because of risk, but most loan structures are negotiated through risk assessment and a loan default probability.
Conclusion
Both residential and commercial real estate are good investments and provide great tax benefits. Managing real estate is essential and sometimes requires the help of a property manager. With commercial real estate loans being between 5 and 20 years and residential loans up to 30 years, you must consider all the factors before investing.
In my opinion, it is important to select the right subclass of commercial or residential property for your personal management preference and one that is in high local demand.