As a real estate investor, one of the first decisions you must make is whether to invest in residential or commercial real estate properties. It’s a crucial decision since both property types come with different return potential, risks, and requirements.
In this article, we’ll discuss the difference between residential and commercial real estate and the pros and cons of investing in each. Let’s get started!
Residential real estate is any property that has between one and four residential units. This could be a single-family home (SFH), condo, townhome, mobile home, or duplex/triplex/fourplex. What all residential properties have in common is that they are used for basic living.
Commercial properties, in contrast, are used primarily for business purposes. They could be industrial spaces, retail stores, offices, hotels, or apartment buildings with five or more units.
Now that you know the main difference between residential and commercial real estate, let’s go over the pros and cons of investing in each:
Long-term leases. Compared to 6-12 month residential leases, commercial property leases usually last five to ten years. This can lead to lower turnover, fewer (costly) vacancies, and more predictable cash flow.
Triple net leases. Many commercial tenants opt for triple net leases, which means they agree to pay not only the base rent but most, if not all, the operating expenses associated with the property. These typically include property taxes, property insurance, and utilities. This leaves you with fewer operational costs and higher profit margins.
Higher-quality tenants. Commercial tenants are usually other businesses with a brand and reputation to protect. Consequently, they are more likely to respect your property and rules. They also come with fewer tenant obligations and legal protections than residential tenants.
More potential to increase property value. Residential property values are highly dependent on neighboring properties. Commercial property values, however, depend much more on the amount of revenue a building can generate. With the right tenant, it’s much easier to increase a commercial property’s value and thereby justify increasing rent.
More sensitive to economic downturns. Because commercial real estate values are tied to business cycles, they are often hit first during economic downturns. The recent office building crisis brought on by remote work is a prime example. Residential tenants, in contrast, will always need a place to live.
Infrequent rent increases. Because commercial properties tend to have longer leases (5-10 years), there are fewer opportunities to increase rents (with residential properties, you can usually increase rents at least once per year).
More complex deals. Commercial real estate is more complex than residential real estate. This is because of the types of tenants, amounts of capital, and zoning laws involved. Consequently, closing good deals will require more research and upfront money.
Low barrier to entry. Buying a single-family home is much more affordable and simple than buying a commercial property. As a result, getting into residential real estate is easier. Plus, most people intuitively understand the landlord-tenant relationship.
Higher flexibility. With residential property, you can choose from many investment strategies: buy-and-hold, rent it out, and fix-and-flip. You can even live in the property yourself if needed. And selling is much easier since living space is always in demand.
Steady demand. Given the constant demand for housing, finding residential tenants can be much easier. You have a much larger tenant pool to choose from. This can lead to more consistent returns, even during economic downturns.
Shorter IRS depreciation schedule. The IRS allows you to write off the depreciation of residential and commercial properties. However, the period over which you can write off the depreciation varies by property type. Residential property depreciation can be written off over 27.5 years, while commercial property depreciation is written off over 39 years. In other words, you’ll earn more in tax breaks faster with residential property.
Shorter lease terms. Most residential properties have leases that last 6-12 months. This means you may deal with frequent turnover and need to market the property to potential replacement tenants more often. Of course, some tenants will choose to stay for long periods, but this is never a guarantee.
Costly vacancies. A vacancy for a commercial property may not make a huge impact on your cash flow if it’s one of many units. With residential properties, however, a vacancy could hit much harder. An empty single-family home, for example, means you’re not making any rental income and will be losing money as a result.
Property values depend on the neighborhood. Residential property values depend heavily on the neighborhood. If crime rates go up or local jobs decrease, your property value may drop. In other words, your property’s value may go down for reasons outside your control.
Regulatory limitations. Residential real estate is often highly regulated. As a landlord, you may be subject to rent control laws and eviction moratoriums. These can keep you from raising rent or evicting non-paying residents (as was often the case during the COVID-19 pandemic).
Ultimately, the best type of real estate to invest in will depend on your personal financial situation and goals. But if you’re interested in investing in a diversified single-family home fund, consider the Invest.net SFR Fund I. Its goal is to achieve above-average capitalization rates for residential properties across the Midwest.