Once you’ve decided to be a part of the real estate investment world, you’ll need to choose whether commercial or residential real estate will be your focus. While both commercial and residential can lead to high returns, different risks and rewards are involved in both investment strategies.
When you understand how to navigate the risks of each strategy, you’ll be able to make an informed decision about which strategy is best for your goals and interests. To avoid getting involved in an investment venture with risks you didn’t anticipate, keep reading to learn everything you need to know about the difference between commercial and residential real estate.
What Is the Difference Between Commercial and Residential Real Estate Investing?
Residential real estate investors purchase properties exclusively for residential living, while commercial real estate investors purchase properties for business purposes. Residential properties are generally rented to individuals or families, while commercial properties are rented to business entities who use the space to produce income.
Types of Commercial and Residential Real Estate Properties
- Single-family detached homes
- Individual condos
- 2–4 unit multi-family properties
- Office buildings
- Retail space
- Industrial buildings (warehouses, data centers, manufacturing plants)
- Storage units
- Hotels and entertainment venues
- Healthcare facilities
- 5+ unit multi-family residential buildings*
- Any building or land used for business purposes
*A residential property containing five or more units is considered commercial real estate because it is part of a large-scale rental business. This type of property is often called residential commercial property.
Investing in Commercial Real Estate
Tyler Cauble, president of commercial real estate company the Cauble Group, explains why he prefers commercial real estate as an investment strategy. He says, “Typically, the amount gained per square foot is often higher than that in residential property. Usually, in commercial properties, there are more tenants to generate income than in residential properties.”
Here are some things to consider when deciding whether commercial real estate investing is for you:
- Long lease terms and low tenant turnover lead to fewer vacancies
- Triple net leases allow landlords to pass maintenance and operation costs to tenants
- Gross rental returns can reach 6–12%
- Vacancies often take longer to fill
- Loans have shorter repayment terms, higher interest rates, and larger down payment requirements
- Commercial real estate is very sensitive to economic downturns
How to Get Started
1. Develop Knowledge of the Market
The best investors are the most informed investors. Start by building a strong knowledge base about the commercial real estate industry and the local market. It’s important to have a thorough understanding of the way your local market behaves. Keep an eye on forecasts for population and job growth. Track listing and sales prices for all types of commercial properties in your area.
Attend conferences and networking events, connect with industry experts who can mentor you, and read as much as you can about the topic. Utilizing the resources available will help you predict the type of budget you’ll need and the unexpected risks that can arise.
2. Evaluate Your Financial Situation
Before you can begin investing, you’ll need to know how much money you have for your first investment. Calculate how much cash you can afford to spend initially, and decide whether you’ll pull equity out of other assets to finance your commercial property.
You’ll also need to decide whether you’ll be willing to personally guarantee a loan. When you personally guarantee a loan, your personal assets will be at risk if you default on the loan. Consider how much risk you’re willing to tolerate to begin your commercial real estate business.
3. Speak With a Lender
Once your financial status is clear, you’re ready to reach out to a lender to discuss your loan options. As a new commercial property investor, a traditional bank is likely your best option for a lender.
While some commercial real estate investments are financed through private investors, most private investment groups like to see a track record of investment success that you may not have yet if you are just starting.
When discussing lending options with a bank, be sure to ask what kind of fees will be involved, what the loan terms are, and whether you will be required to personally guarantee the loan. Your lender will help you determine what you need in order to qualify for a loan.
4. Find an Experienced Commercial Real Estate Agent
With your financing squared away, you’re ready to find a real estate agent to help you find the right property and navigate the purchase process.
While a licensed real estate agent can sell both commercial and residential properties in most states, usually, agents specialize in one or the other. It’s important to work with an agent who is highly experienced in commercial real estate. The commercial and residential real estate markets follow very different trends, and a residential agent may not be aware of vacancy rates, rental prices, and the rate of demand in the commercial market.
Commercial agents often have a degree in business or finance because the commercial real estate market is very complex. To guide you through the process, your commercial real estate agent should be able to help you calculate internal rates of return, capitalization rates, and gross rent multipliers.
Investing in Residential Real Estate
The key differences setting residential real estate apart from commercial include the financing process and the stability during economic downturns. Because people always need a place to live, the demand for residential rental properties endures tough times. This allows lenders to feel more comfortable providing loans to residential real estate investors.
Here’s what you need to know about residential real estate investing:
- Loans have lower interest rates, requiring less cash upfront
- They also have longer loan repayment terms, making it easier to finance investments
- The value of residential property and the price of rent typically remain stable during economic downturns
- At 3–5%, rental yields are generally lower than commercial properties
- Shorter leases and higher turnover lead to more frequent vacancies
- Landlords pay for many operating costs like maintenance, taxes, and insurance
How to Get Started
1. Learn the Industry
If you want to learn how to get into real estate as a residential real estate investor, you should study the industry and the local market. Watching the price of homes in your area will give you a good idea of what you can expect to pay for an investment. Whenever you have spare time, you should also be consuming as much educational material as possible.
Because residential real estate investing is a common investment strategy, there are also numerous opportunities for getting advice from people further along in their investment careers.
Study successful investors like:
- Barbara Corcoran: Corcoran grew up in a low-income household and used real estate as a stepping stone to greater financial security. She now has a net worth of over $100 million and creates educational content for new investors wanting to reach similar levels of success.
- Graham Stephen: Stephen entered the real estate industry at 18 years old and now runs a YouTube channel providing advice to young investors wanting to start building wealth.
- Phil Pustejovsky: Formerly homeless and living out of his truck, Pustejovsky is now a real estate investor and mentor with a net worth of over $6 million. He believes his investment success is a result of the mentors he worked with early on.
- Investors specific to your area: Attend networking events in your area to meet potential mentors who know what makes investing in your local market unique.
2. Figure Out Your Financing
The next step in residential investment is consulting with a lender about the type of investment property you can afford. Reach out to a few lenders to discuss potential interest rates and closing costs. A 2018 Freddie Mac study found that “borrowers could save an average of $1,500 over the life of the loan by getting one additional rate quote and an average of about $3,000 for five quotes.”
In some cases, you may need to find tenants for your residential real estate investment before qualifying for a loan. But if your personal income is high enough or if you have a large down payment saved, your lender may not require this. Ask your lender what you’ll need to qualify and how large your budget should be. Once your lender has answered these questions, you’re ready to look at properties.
3. Work With an Agent to Find Your First Property
A highly qualified residential real estate agent is the key to success for residential real estate investors. A great agent can tell you about good investment properties as soon as they hit the market. Experienced agents often know how to spot potentially costly issues in a home, and they may have connections with skilled contractors.
Once you have a good agent, discuss your investment goals and the type of property you’re looking for. Keep your eyes open for that perfect property, and be ready to move quickly once you’ve found the right one.
FAQ: Commercial Real Estate vs. Residential Real Estate
What are the key differences between commercial and residential real estate loans?
One of the main reasons many real estate investors start in residential real estate instead of commercial is that residential real estate loans are typically more affordable and easier to obtain. While residential real estate properties can be purchased with a down payment of 20% or, in some cases, 15%, commercial real estate loans often require a down payment of up to 35%.
The most common repayment period for residential real estate loans is 30 years. Commercial real estate loans often have terms ranging from 5–20 years, meaning monthly payments can be quite high.
In some cases, the amortization period is longer than the term of the loan. This means although your loan might be due in 10 years, the monthly payments look like a loan that is paid over 30 years. This lowers the monthly payments, but when the loan is due, you’ll be required to pay back the remaining balance all at once (called a balloon payment).
How do utilities differ with commercial vs. residential real estate properties?
Both residential and commercial landlords typically pass some of the expense of utilities to their tenants. In residential properties, tenants often pay for electricity, gas, and internet, while the landlord covers the cost of water, sewage, and garbage. Commercial property owners often require tenants to pay all utility bills, including sewage, garbage, and water.
While commercial property owners may not be paying for the electric bills, they should understand how electricity is billed differently to commercial buildings. Energy companies provide different plans for customers who use high amounts of electricity. Because commercial buildings use significantly more energy than residential properties, they often qualify for a plan with better rates than residential property plans. Reach out to your electricity provider to discuss different rate options for commercial buildings, so you don’t leave available benefits on the table.
How is working with contractors different for commercial vs. residential real estate properties?
If you have experience working with contractors in residential real estate, it’s important to note that the process is different for commercial real estate. Commercial and residential buildings are structurally different and have different regulations.
While most residential properties have wood frames, commercial properties are often built with steel and concrete. This means renovations require different tools and materials, as well as laborers who understand how to work on commercial projects.
Regulations are also much more strict for commercial buildings. When you change a commercial structure, the permitting process is likely to be longer and more complicated. Everything from the location of the loading dock to the construction of the windows is subject to regulations. The permitting process can be complicated, and your project could be significantly delayed if your contractor isn’t familiar with the requirements. Make sure to find a contractor that has worked on similar projects.
Diversifying Your Portfolio
Because commercial and residential real estate both have strong returns, investors who build both into their portfolios will likely see success in their investment careers.
Team Denver Homes’ co-founder Mor Zucker explains in a Forbes article, “I diversify my own portfolio, which consists of a multi-unit property, two single-family homes, two condos, and a commercial building, which gives me a good balance of income and appreciation . . . The biggest advantage of diversification is that you can create a portfolio that is geared toward both long-term appreciation and monthly income.”
However, Zucker recommends building experience before diversifying. Perfect one investment strategy, and then move to the next for the most success with your real estate investing career.
As a brand new investor, follow these steps to grow your portfolio into a diversified, high-income producing business:
- Start building equity through residential real estate.
- Use the equity from your residential investments to finance a commercial investment.
- Leverage equity from both your residential and commercial investments to continue adding a mix of investment properties.
- Never stop researching and learning about the best real estate investment techniques.
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