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We hear this often from property investors: “What’s the smarter move? Commercial or residential investment property?” It will come as no real surprise there isn’t a one-word answer to this question. You’ll arrive at your very best choice — the one that maximizes your chances for achievement — by working via a decision process that includes some “global” issues, some local and some that are entirely personal.
Definitions
Let’s start with some terminology. For the purpose of our discussion, we’ll define as residential any property that derives any nearly all of its income from dwelling units. Single-family homes, multi-families, apartment buildings, condos, co-ops are residential. (FYI, the tax code classifies any property in which 80% or even more from the revenues comes from dwelling units as residential, a lot of mixed-use properties could be classified as residential for tax purposes.)
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.
Why do I only say that this may be the layman’s definition? Because appraisers and lenders would consider large (>4 unit) apartment buildings to become commercial investment property since they are bought and sold strictly for their ability to produce income and never like a potential personal residence for that owner/investor. However, it’ll suit our discussion better to treat all apartments as residential properties.
Global Issues
Do you know the global problems that should affect your decision to purchase residential or commercial property? Your the U.S. economy certainly tops the list. If you believe we’re in or are on the brink of the recession, then it is sensible to become cautious regarding commercial property. You will have to depend on businesses to occupy your commercial space, and if they’re struggling to survive or simply deferring their intends to expand, then rental rates may soften and demand for space decline. Replacing a lost tenant — especially one lost unexpectedly (in the center of a lease, or even the core night) because of a weak economy — may take more than it might in unstressed economic times. Once the economy and employment are strong, obviously, you’ll probably see the opposite. Service businesses need more space, retailers open more stores, distributors need more warehouses.
Something may be the cost and accessibility to financing. Rates of interest are always important to investors, but there’s one situation that could strike you as counter-intuitive. When home loan is easily available and rates on mortgages rising drop, it’s not uncommon to determine a rise in apartment vacancies, making apartment buildings less desirable as investments. The main reason? Low rates on mortgages rising and easy credit often imply that individuals can own a house in a monthly cost that is the same — or less, after taxes — than renting. So part of your potential tenant pool may be lost to home ownership.
Local Issues
In the real world, all these global issues comes with a “however” attached. You need to stay on top of the local market because that market may contradict the nation’s trend. For example, highly restrictive zoning regulations often means that commercial space is definitely in short supply in a particular location, recession notwithstanding. And the cost of single-family homes in your neighborhood might be so high that there will be a strong demand for rentals. Think globally but act locally (with apologies to environmentalists for borrowing their slogan).
Personal Issues
You can buy a property and then insulate yourself from it by generating every aspect of its operation to some management company. But if you haven’t operated a property yourself, how would you determine if the management firm does an acceptable job? Most investors begin as hands-on managers as well as your chances of success is going to be greater if you choose a type of property that you’re comfortable with.
So, in the personal level, will residential or commercial suit you better?
Unless you were raised within the woods by wolves, there’s a very good chance that you’ve spent much of your life in a residential dwelling unit: a single-family house, a condo or an apartment. You’ve got a first-hand knowledge of the rights, obligations and appropriate behavior of a residential occupant. If you were a tenant, you probably also know something about the roles and responsibilities of both tenant and landlord. It is for this reason that first-time investors often lean toward buying a small residential building. You might not know the fine points of leasing and landlording, but you understand the basic guidelines. This is familiar and comfy territory.
Obviously, some novice investors arrived at property having a background in business and maybe like a commercial tenant. In the event that description fits you, then being a commercial landlord might be an easy transition. You have firsthand understanding of how commercial lease deals get together, and what the parties typically expect of each other.
The Pros and also the Cons
Like any of the investment choices, each kind of property has its own pros and cons. For instance:
Residential Pros:
1. Residential units are usually simple to rent. Turnover in housing is high, so your pool of potential tenants tends to be large.
2. Leases are usually short, specifically for apartments, to help you keep pace using the rental market. What this means is cash flow is commonly fairly strong with a multi-unit house.
3. Financing residential property is generally fairly straightforward. For smaller properties, the process is similar to financing a house.
4. The price per unit tends to be lower for residential than commercial. The more units you’ve, the not as likely it is that a vacancy will severely impact your money flow.
5. You can live in among the units of the multi-family property. Obviously it’s simpler to keep close track of the property in case your eye is actually there.
Residential Cons:
1. Residential properties usually require a large amount of hands-on management.
2. Residential properties usually require a lot of hands-on management. (That’s not a typo. I said hello twice.)
3. With a single-family home, one lost tenant equals 100% lost rent.
4. Multi-family houses tend to be older and for that reason may need more repairs and maintenance.
5. Residential tenants don’t keep office hours, so you can get a phone call or complaint at any time of day or night.
6. Larger multi-unit properties generally have lots of traffic in keeping areas and will require greater upkeep.
7. Did I mention that residential properties usually need a large amount of hands-on management?
Coping with commercial tenants is quite different. Ideally, it’s business, not personal. You might need a personal guarantee on a lease, however, you should expect to have much more of a business-to-business relationship.