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If you're thinking about getting into real estate investing, you may be wondering whether commercial or residential properties are a better fit for your portfolio. Each option comes with its own set of advantages and challenges, and the right path for you ultimately depends on your situation, goals and other factors.
If you're trying to decide between investing in commercial and residential real estate, here's what you should know.
How Does Residential Real Estate Investing Work?
Residential real estate includes any type of unit you can rent out to tenants for the sole purpose of living. You can invest in single-family homes with one tenant or multi-unit properties with several tenants.
You'll collect rent from your tenants and use that money to pay the mortgage, property taxes, insurance, maintenance costs and other expenses. You'll also benefit from the property's appreciation in value over time.
Residential real estate is generally best for beginner investors who don't have a lot of capital, as well as for seasoned investors who prefer a simpler approach to real estate investing.
Pros
- Low cost of entry: Residential properties are typically much less expensive than commercial properties, so it's easier to get one if you're relatively new to real estate investing or if you don't have a lot of cash on hand.
- More flexibility: As the owner of the property, you can choose to rent it out or occupy it yourself. Depending on your plans, that kind of flexibility can provide a significant advantage. If you want to get rid of the property, you can sell it to another investor or someone who wants to live in it.
- Larger tenant pool: While more businesses go partially or fully remote, people still need a place to live. You'll likely have an easier time finding good residential tenants regardless of your market.
Cons
- Shorter lease terms: Many residential leases are for 12 months or less, which could mean higher turnover in some areas. Even if you get a good tenant that stays in the home for years, you still have to plan for the potential that you'll need to find a new tenant.
- Vacancies can hit harder: If you're renting out a single-family home and the tenant doesn't renew their lease, you won't get any income from the unit while it sits empty. In contrast, with commercial real estate, you may have multiple tenants in a building, so one empty unit won't have as significant an impact.
- Regulatory limitations: Depending on where you live, you may be subject to rent control laws that limit how much you can raise your rent each year. During much of the pandemic, landlords were unable to evict tenants for nonpayment of rent due to the eviction moratorium.
How Can You Invest?
Much of the process of investing in residential real estate is similar to buying a property for yourself. You'll either work with a broker or an agent to find the right property, then when you complete the purchase, you'll find a tenant to live in the unit rather than occupying it yourself. You can choose to work with tenants directly or hire a property manager as an intermediary.
How Does Commercial Real Estate Investing Work?
Commercial real estate properties are generally used for business and not everyday living. Properties can come in all shapes and sizes, and potential tenants can include offices, retail spots, hotels, industrial companies and more.
As with residential real estate, you'll purchase the building and land it occupies and collect rent from one or more tenants.
Pros
- Longer leases: It's not uncommon for commercial leases to last between five and 10 years, which could result in lower turnover and fewer vacancies. This could mean more predictable cash flow and fewer turnover-related costs.
- Triple net leases: With this type of lease, the property owner passes the costs related to insurance, property taxes and building operating expenses to the tenants, which means less risk in that regard.
- Higher return on investment: Commercial properties tend to perform better than residential properties over time, both in terms of income and appreciation. It's also easier to add value to commercial properties, which could make it easier to justify increasing rents.
Cons
- Stuck with lower rents: Because leases are longer, you won't be able to increase rents to match market rates as often.
- More complex: You'll need to deal with zoning ordinances, unique requirements from each tenant, more complicated contracts and other complexities that you don't have to deal with if you're investing in residential real estate. There are also the higher upfront cash requirements to get into commercial real estate to begin with.
- Risks related to individual sectors: Depending on which type of commercial properties you're investing in, you may be subject to risks specific to that commercial sector. For example, demand for office buildings plummeted during the beginning of the coronavirus pandemic when businesses went fully remote.
How Can You Invest?
You can invest in commercial real estate by working with a broker or agent or by searching for properties on your own. You'll need to familiarize yourself with the different financing processes, and you'll definitely want to hire a property manager to work directly with your tenants.
Is Commercial or Residential Real Estate a Better Investment?
Ultimately, neither option is inherently better than the other. Commercial real estate can offer better long-term returns than residential real estate, depending on the sector, but that's not always true.
Let's take a look at the average returns for a handful of different types of property investment between 2012 and 2021 based on data from the National Association of Real Estate Investment Trusts (Nareit):
| Average Real Estate Returns by Time Frame | |||
|---|---|---|---|
| Property Type | One-Year | Five-Year | 10-Year |
| Residential | 58.29% | 17.64% | 15.14% |
| Office | 22% | 5.15% | 8.48% |
| Industrial | 62.03% | 28.2% | 23.4% |
| Retail | 51.91% | 5.53% | 8.94% |
| Self Storage | 79.43% | 22.54% | 20.61% |
That said, the costs and complexities associated with commercial real estate may not be worth it for some investors. As you grow your real estate business, however, it may be worth it to own each type to better diversify your portfolio.
How Much Does It Cost to Invest in Real Estate?
Most mortgage lenders require you to put down at least 15% on an investment property, and interest rates tend to be higher than they are on primary residences. With a commercial lender, however, you'll usually need to put down at least 20%, and because commercial properties tend to be more expensive in general, that means you'll need more cash on hand.
If you want to invest in either commercial or residential real estate without the massive upfront cash requirements, you can opt for real estate investment trusts (REITs) instead. These companies trade on public exchanges and invest in several properties to provide you with income and growth through diversification.
How to Get Your Credit Ready for Real Estate Investing
If you opt to invest in real estate through REITs, you don't need to worry about where your credit history stands. But if you want to start buying and flipping or renting out residential properties, or buying and renting out commercial properties, you'll need to finance your investment, which requires a stellar credit history if you want good terms.
Start by checking your credit score to get an idea of your overall credit health. Then, review your credit report to see if there are any issues you can address. This may range from paying down credit card balances to disputing inaccurate credit report information.
As you monitor your credit and track your progress, you'll be on the right track to get started.