Investing in real estate brings numerous benefits. It can provide passive income, predictable cash flow, and a diversified portfolio. If you’re a beginner, one of the challenges you have to face is deciding what type of property to invest in.
Commercial properties and residential properties are the two most common types of real estate investments. As an investor, it’s important to understand the advantages and disadvantages of each one before making a decision.
Defining commercial and residential real estate investments
The main difference between a commercial property and a residential property is its usage.
Commercial properties are typically rented to businesses. Offices, malls, and grocery stores are just some of the types of commercial properties. However, a residential building with five or more rental units is also classified as a commercial property.
Residential properties are specifically intended for people to live in. There are several types of residential properties, including single-family homes, condominiums, apartments, townhouses, and multi-family homes with less than five units. One of the most common routes to residential real estate investments is flipping houses and turning them into rental properties.
Commercial properties and residential properties are valued differently, as well. The price of commercial properties is largely based on their rental returns. The most common method in getting the value of a commercial property is the Income Capitalization Approach, which makes use of the cap rate, or the net operating income of the property is divided by its current market value
As for residential properties, their value depends largely on the neighborhood, size, age, condition, and the local real estate market. Appraisers look at real estate comps, which are the similar properties that are of similar location, condition, and features.
Pros of commercial real estate
- Higher returns
- Longer lease terms
- Portfolio diversification
- Triple net lease
While the costs of managing and investing in a commercial property are higher, the returns are also bigger. According to Nolo, commercial properties have an annual return of 6% to 12% off their purchase price.
Unlike residential properties, the lease for a commercial property typically runs for one year to ten years. The longer lease terms mean a steady cash flow due to the low vacancy rate and turnover costs.
Looking to diversify your portfolio? A commercial property could be the answer. This property type has historically strong returns, stable cash flows, and positive leverage. There are also a wide variety of commercial properties to choose from.
One of the advantages of owning a commercial property is being able to utilize a triple net lease. Also known as the NNN lease, this real estate agreement puts the tenant in charge of paying for the real estate taxes, maintenance, rent, utilities, and other ongoing expenses for the rental property. By using the triple net lease, landlords secure their investment at no cost to them (except for the mortgage) while enjoying a steady income stream.
Pros of residential real estate
- Lower cost of entry – For first-time real estate investors, residential real estate is most ideal. Investing in a residential property requires less capital than in a commercial property. Loans for a residential property are also more accessible, and the process for buying one is simpler. If you’ve purchased a house as your primary residence, you are most likely already familiar with the home buying process.
- Easier management
- Larger buyer and renter pool
- High demand
Owning a commercial property typically means managing multiple tenants at a time. For a residential property, you’ll usually get just one group of tenants. Managing a residential property is also easier in terms of rent collection, maintenance, and repairs, especially if you only own one property.
Since people are always looking for a place to live in, you can expect low vacancy rates with residential properties. The renter population has been rising in the US. According to this 2017 report from Pew Research Center, more households are renting now than in the last fifty years.
Residential properties are more flexible in the event of an economic downturn. In a recession, for example, retailers and other businesses are usually the first to be affected, which in turn, significantly affects the commercial real estate business. Housing, on the other hand, will always be in demand. Despite having longer lease terms, having a tenant stay until the end of a commercial lease is not guaranteed.
At the end of the day, the best investment property is the one that aligns with your goals. If you’re after high returns, commercial real estate may be the better option. But if you prefer a real estate investment of a smaller scale, then a residential property just might be the right one for you.
A knowledgeable real estate team can give you valuable insights and information on which kind of property to invest in. At RE/MAX Direct, our award-winning team offers expert real estate advice for buyers and investors. Call us today at 610.430.8100 or send an email at remaxdirectwc(at)gmail(dotted)com.