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Before we weigh the pros and cons between a residential property and a commercial property, let’s define the two real estate terminologies.
A residential property is any property that derives all or nearly all of its income from dwelling units. Single-family homes, multi-families, apartment buildings, condos, co-ops are all residential.
For commercial property, we’ll use a typical layman’s definition: property that derives its income from non-residential sources, such as offices, retail space and industrial tenants.
The Pros and the Cons
Like any of your investment choices, each type of property has its pros and cons. For example:
Residential Property Pros:
Residential units are generally easy to rent. Turnover in housing is high, so you can usually count on an ample pool of potential tenants.
Leases are generally short, especially for apartments, so you can keep pace with the rental market. This means cash flow tends to be fairly strong with a multi-unit residential property.
Financing residential property is usually fairly straightforward. For smaller properties, the process is often similar to financing a home.
The cost per unit tends to be lower for residential than commercial. The more units you have, the less likely it is that a vacancy will severely impact your cash flow.
You could live in one of the units of a multi-family property. Obviously, it’s easier to keep an eye on the residential property if your eye is actually there.
Residential Property Cons:
Residential properties usually require a lot of hands-on management.
With a single-family property, one lost tenant equals 100% lost rent.
Multi-family houses tend to be older and therefore may require more repairs and maintenance.
Residential tenants don’t keep office hours, so you can get a call or complaint at any time of day or night.
Larger multi-unit properties generally have a lot of traffic in common areas and will require greater upkeep.
Dealing with commercial tenants is quite different. Ideally, it’s business, not personal. You may require a personal guarantee on a lease, but you should expect more of a business-to-business relationship.
Commercial Property Pros:
Typically leases are longer, with built-in rent escalations. Except perhaps for small offices, few businesses would be willing to go to the expense of becoming established in a particular location without a guarantee of more than just one year. Five years, with options to renew, is not universal but certainly quite common.
Many commercial leases pass through to the tenant a pro-rata share of certain expenses (or a pro-rata share of the increase in certain expenses, over a base). For example, the tenant may be obligated to pay a pro-rata share of property taxes and common-area maintenance. This helps stabilize the cash flow for the landlord and makes that cash flow more predictable.
Management is less hands-on than with residential. Renewals are less frequent. Many commercial leases are written to include the requirement that the tenant be responsible for interior repairs, HVAC maintenance, glass breakage, etc.
Depending on the type of space (i.e. more common with retail and high-end office), the tenant may fit-up the space to suit itself. The landlord may give a one-time fit-up allowance or a period of free rent, but the interior finish is then the tenant’s responsibility to maintain.
Because a commercial property’s value is a function of its income stream, you have the opportunity to create value by enhancing that income stream. In other words, you don’t need to rely on general market “appreciation” to increase the value of your property but can take steps to do so yourself.
Commercial Property Cons:
Trying to purchase a commercial property on a shoestring may not be a realistic plan. Lenders are generally tougher underwriting commercial loans, especially if you have no experience operating such property. Down-payment requirements tend to be higher, as do interest rates. Loans are for shorter terms and often have a “balloon” requirement (i.e., must be refinanced before the nominal end of the term). The property will have to pass muster in terms of its projected cash flows and debt coverage ratio.
Leasing a commercial space can take a good deal longer than leasing a residential unit. After a tenant is identified and basic terms agreed upon, it is usually necessary for attorneys for both sides to negotiate the language of the lease. The complexity and cost of this process can vary greatly.
Filling a vacancy can also take longer than with a residential unit. For this reason, commercial leases will typically require that a tenant exercise an option to renew well before the lease expires – perhaps six to as much as twelve months prior – so that the landlord can have ample time to look for a new tenant.
Financing commercial property can be more complex than with residential. You’ll need to demonstrate to the lender that the property will perform at a level that can cover the debt service with room to spare.
If you don’t have experience being a commercial tenant, then becoming a commercial landlord may require that you get familiar with some concepts and skills that are particular to the commercial world. You’ll want to learn about “tenant mix” if you own retail space, about commercial insurance and about the billing and reconciliation of pass-through expenses.
The benefit of net leases (where the commercial tenant reimburses you for some or even all of the operating expenses) must necessarily involve a trade-off. Since there is less risk to the investor, you may expect that the return will be less than with more volatile properties.
While there is certainly no right answer to the question, “Residential or commercial?” there is probably a best answer for you. Do you want the hands-on involvement of residential? Do you have the resources for commercial? Do you want the potential for higher cash flow, and with it the possibility of greater risk? Do you prefer a more modest but more predictable return? Consider your objectives and preferences carefully, and evaluate your resources – time, money, skills – realistically. With a bit of luck, the answer should jump off the page.