The commercial vs residential real estate debate has piqued the interest of new and seasoned investors alike. If for nothing else, it’s a legitimate question: What is the difference between residential and commercial real estate? Perhaps even more importantly, should investors focus on commercial or residential real estate? The answer is simple: both exit strategies award investors with significant benefits. In fact, there is no need to choose between the two. The only differentiating factor will ultimately be what each individual investor hopes to get out of a deal.
On the surface, the differences between residential and commercial real estate appear to be obvious. To that end, residential real estate is reserved for personal residences, whereas commercial real estate intended to play home to businesses and companies. Not surprisingly, their names suggest their dedicated uses, but there’s a lot more to it than that. The differences between residential and commercial real estate are exhaustive, and go beyond their intended use.
Residential real estate is often defined by its primary use and zoning ordinances. Not surprisingly, residential real estate includes physical properties located in areas that were developed for homeowners to live in. It is also worth pointing out that residential real estate, by definition, can’t be used for industrial or commercial activities. In other words, residential real estate is essentially a real estate asset that was built to serve as a home. Beyond the use of the property, residential real estate is often anywhere from one to four units; anything more and the real estate ventures into commercial territory.
Commercial real estate is in stark contrast to its residential counterpart. Instead of being built to serve as someone’s primary residence, commercial real estate is designated by local municipalities and zoning laws to serve as a physical location for a place of business. More specifically, it’s an area’s local laws that will play the biggest role in determining whether or not a physical asset is commercial or residential. Areas zoned for commercial properties will permit a wider range of building types and their specific uses. Last, but certainly not least, buildings with more than four units will be classified as commercial.
Despite exhibiting several unique differences, however, both commercial and residential real estate boasts several of the same benefits. If for nothing else, many of the reasons entrepreneurs choose to invest in real estate in the first place are directly correlated to the real estate industry, and not just a specific niche. Regardless of the niche, in fact, investors may be able to take advantage of the following benefits:
Tax Shelter: Significant tax advantages awarded to those who own real estate offer investors a way to combat losses at tax time. Rental properties, condos, raw land, commercial buildings, industrial complexes, shopping centers and single-family homes each offer their own variation of tax incentives, not the least of which may help offset yearly income taxes.
Profits: Whether profits are realized through the sale of a home or through cash flow, real estate has the potential to create some of the highest returns in any industry.
Hedge Against Inflation: Real estate may act as a hedge against inflation. Whereas many investments, like stocks for example, increase in the face of inflation, real estate allows investors to capitalize on its proportionate inflation. You see, as inflation occurs, so too do rents and home values, essentially increasing the value of each respective asset.
Leverage Funds: While real estate is more expensive than most investment opportunities, it’s able to be purchased by leveraging other people’s money. In fact, there’s almost never a need to use one’s own money, as private and hard money lenders are often willing to leverage their funds for investors to secure a deal. Sure, their services will cost investors (often times around 12% to 15% in interest), but the ability to leverage funds allows investors to remain liquid, let alone the ability to invest altogether.
Equity: Appreciation is never guaranteed, but real estate has appreciated more often than not. That said, there’s a good chance investors will be able to build equity in whichever assets they hold for long periods of time.
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Most investors break into the real estate industry hoping to realize some or all of the benefits listed above. However, the residential real estate sector has some additional benefits they may need to consider, too. For a better idea of what someone may expect when investing in residential real estate, please take a look at the following benefits:
High Returns: The single greatest benefit associated with residential real estate investing is the industry’s high return rates. In fact, the average annual return on long-term residential real estate investing trumps the S&P 500, averaging 10.6%.
Lower Barrier Of Entry: While residential real estate is by no means a cheap asset, it is usually considerably less expensive than commercial real estate. The sheer size of commercial properties typically lends itself to higher price points. As a result, it’s usually easier for new investors to get their start in residential real estate because it costs less money. Not until investors start making money though residential real estate do they typically have enough money to consider commercial deals.
Persistent Demand: There is always a demand for residential real estate. Whether the economy is up or down, there is never a lack of prospective buyers. Commercial real estate, on the other hand, is heavily influenced by market fluctuations.
Larger Buyer And Renter Pool: Due the persistent demand for real estate and growing population, homeowners will always have a large pool of buyers and renters to sell and lease to. That means marketing a property for sale or rent will have a better chance of closing sooner rather than later.
In addition to the benefits that have become synonymous with investing in real estate, commercial properties award investors a few more advantages, which begs the question: Is commercial real estate better than residential? The answer will depend on what investors hope to accomplish. However, here are some of the most popular reasons investors choose to invest in commercial real estate:
High Returns: Commercial real estate spaces have become synonymous with higher prices. Acquisition costs are typically much higher with commercial properties, but that means there’s a good chance their returns will be much higher, too. If for nothing else, the value of a commercial unit is usually determined by its profit potential. A good unit in a good building could earn commercial investors a significant return on their investment. According to Investopedia, “Average 20-year returns in the commercial real estate slightly outperform the S&P 500 Index, running at around 9.5%.”
Quality Tenants: Most businesses leasing a commercial space are well aware of their position and don’t want to do anything to jeopardize the future of their company, which means a great deal of the tenants will treat the property with the same amount of respect as their own home—if not more. That means commercial landlords may not have to worry as much about the condition of their units.
Triple Net Leases: Triple net leases represent agreements on behalf of commercial property owners and renters. As their names suggest, triple net leases will have the tenant pay all of the resulting real estate taxes, building insurance and maintenance (otherwise known as the three “nets”). Naturally, the renter will cover a great deal of the costs, which improves profit margins for the owner. That said, not all commercial real estate deals have ripple net leases.
Longer Lease Terms: Whereas most residential lease terms are about a year long, it’s not uncommon for commercial leases to triple their residential counterparts. In fact, most businesses would prefer leases upwards of five to two years, which bodes well for commercial investors. The longer periods inherently reduce turnover, and make life easier for those renting out commercial properties.
Revenue-Based Valuation Model: Commercial real estate receives a great deal of its value from comps (comparables), but the true market value of a commercial property is more impacted by its ability to generate revenue. That means real estate investors may be able to increase the value of a commercial property easier than that of it’s residential counterparts that are primarily valued by examining the raw characteristics of nearby homes.
The commercial vs residential real estate debate is fueled by several differences, not the least of which include financing. At the very least, any sort of commercial vs residential financing comparisons will bring several differences to the surface. Everything from terms and conditions to penalties and qualifications will vary significantly between commercial and residential loans. The most notable difference, however, is the duration of loans for each asset class. Whereas most residential mortgages will span approximately 30 years, and coincide with longer amortization periods and smaller monthly payments, commercial loans are typically shorter (often lasting anywhere from five to 20 years).
While commercial and residential real estate are each a part of the same industry, there are inherent differences between the two exit strategies, none the least of which have sparked many a commercial vs residential real estate debate. However, for as many differences as there are between the two asset classes, none may be more prominent than the reason someone would choose to invest in them. If for nothing else, it’s what investors want out of investing that will ultimately determine which strategy is best for them. Those looking for quicker turnarounds and larger, upfront sums of money will most likely want to consider flipping residential real estate. Those in it for the long haul, however, will probably be drawn to the prospects of commercial properties.
The biggest difference between commercial real estate and residential real estate is perhaps the reason someone would consider investing in the first place. If for nothing else, there are significant advantages to each exit strategy; both have proven to be excellent investment vehicles. However, each class has something different to offer over prolonged periods of time. Therein lies the answer to the commercial vs residential real estate debate: the best class is ultimately the one that will get you one step closer to your own goals.