Success in real estate investing begins with a basic understanding of the differences between residential and commercial real estate. Diving into the world of real estate investing is a daunting move, to say the least. Determining the right kind of investment, property type, developer, and other factors are all important real estate calculations to consider when an investor is starting out.
The first decision investors most often have to make is between commercial real estate investments or residential real estate. Both types of real estate investments have the potential to build wealth and earn passive income for investors wanting to diversify their funds and move into real estate, but each investor must consider what kind of investment is worth their time and resources.
There are essential factors to consider when deciphering between commercial and residential investment. Discerning which real estate investment is right for any investor will be primarily based on their interests, risk tolerance profile, and of course how much available capital they have. Ultimately, once a decision has been made about the type of investment anyone wants to make, a seasoned real estate developer can be an invaluable resource in helping to navigate the world of real estate.
The moment investors decide between commercial versus residential real estate, a great next step is to find a knowledgeable and experienced developer with a seasoned portfolio to help you continue on your journey. Significant diversification into real estate investing won’t be a quick or rash decision, but going in with as much information as possible and a foundational understanding of the pros and cons of both commercial and residential can help the initial steps seem much less mystical. When you’re ready to make a move on real estate, take a look at Trion Properties’ portfolio with multi family and residential real estate to find out where your next project lies.
What Is Commercial Real Estate Investing?
Commercial real estate investing refers to investment in a building or piece of land that is leased to businesses as tenants, that are large enough to be run as commercial enterprises (like large scale apartment complexes), or that financial institutions define as being for lending purposes. Even though there are several types and subtypes of commercial investing, commercial real estate can be divided into five main categories – office, industrial, retail, residential, and hospitality.
Types of Commercial Real Estate Investing
While not always, most developers like to focus on one specific type of real estate to specialize in. Most reputable commercial developers have a good knowledge of commercial and residential real estate and can sell and lease any property. But as with any other industry, you’ll often find that each real estate brokerage you come into contact with has a particular passion and expertise for one of the five main types of real estate. It’s not difficult to find a commercial real estate developer that will have experience and knowledge for whatever kind of property you’re most excited to explore. Remember, a seasoned developer can handle every element of buying property as you earn a sustainable passive income.
Industrial Commercial Real Estate
Of the five major types of commercial property, industrial commercial real estate probably has the longest term and largest square footage leases of all. This is particularly true in recent years; as e-commerce has come to dominate the buying patterns of consumers, the demand for vast warehouses across the nation has skyrocketed. There are many that requirements industrial tenants usually need, but once this kind of building or property is leased, they can be an excellent source of income for real estate investors. However, the scale and duration of the commercial property lease is a double-edged sword. It’s great for as long as you have a tenant, but since these commercial properties depend on single tenants, a vacancy can mean the difference between sustained income and total loss.
Retail Commercial Real Estate
Much talked about in recent years, and another product of the growth of e-commerce, the retail industry is seeing some transformational changes – though not as exuberantly as the industrial space. Shopping habits are changing as consumers increasingly buying property online, and it is the retail sector that has taken the brunt of these changes. While opportunity certainly exists, the volatility of retail real estate makes it an avenue for only the most confident and risk- tolerant of investors. Buying property in retail commercial real estate is most definitely not for the faint of heart.
Office Commercial Real Estate
Like the industrial sector, the office sector benefits from longer-term leases. Unlike industrial commercial real estate, this kind of commercial investment consists of smaller square footage. Susceptible to economic downturns as businesses shut down or reduce costs by reducing leased space as employment goes down, office buildings provide another investment opportunity, like industrial real estate, in which the tenants do not live in the buildings they lease.
This is an important distinction because the two remaining types of commercial real estate both involve occupants who reside in them for varying lengths of time.
Multi Family Real Estate
Multi family real estate, AKA apartments, are definitely residential but also fall into the commercial real estate category because they do not involve residences that their occupants own. Even this distinction has an exception; large-scale tract home developments are, while clearly residential, also fall into the commercial bucket. Multi family projects are most commonly associated with buying property, improving older apartment buildings or developing new buildings from the ground up.
Related: The Role of the Multi Family Industry in the Housing Shortage Scenario
Hospitality Real Estate
The fifth of the five major commercial property types is the hospitality sector. Of all asset classes, this real estate investment type is the only group that really should be considered primarily as an operating business where the bulk of all expenses comes from running the ‘business’ of the hotel than from managing the real estate per se. This asset class, while it can be very lucrative for investors, is also the most susceptible to economic swings as the discretionary income upon which it relies from its customers is the first to be curtailed during recessions.
What is residential real estate investing?
Residential real estate investors own and rent out single-family homes or other residential areas in smaller capacities. The primary motivation and reasons for newbie investors to pick residential over commercial almost always have to do with available funds. Not everyone has the kind of disposable income that it takes to be able to invest in a large commercial property that requires considerable management and execution expertise.
There is a typical image of someone who owns real estate investments that an average person conjures up when entertaining the idea of investing in real estate: a guy getting a call on a Sunday from a tenant because their toilet is overflowing, and the owner of the property having to deal with never-ending problems that each homeowner faces on a day to day basis. When you’re dealing with where people live, management will always be a must, and sometimes some inconvenient management at that. The fortunate part of having a seasoned developer as a partner is the assurance this is something they can take on, and the residential real estate investor can focus on their ventures instead.
There’s no shortage of calculations to make when thinking about buying residential property for investment. However, if someone is considering residential investment, rent collection isn’t the only source of income that is potentially pulled from residential real estate. Ancillary real estate investments and real estate appreciation are also stable sources of income with residential real estate investing. For those starting in real estate, residential is a great option to get an investor’s feet wet and be sure that real estate investment is right for them without risking a ton of capital. It’s also an excellent way to diversify one’s portfolio.
Commercial vs Residential Real Estate Investing Differences
Why Commercial Real Estate?
It’s no secret that commercial real estate is where the high return on investments can thrive and primarily this is because commercial real estate is almost always managed by professional real estate experts working with teams of specialists. Economies of scale and the ability to farm out all aspects of property development and management to others makes commercial real estate investing potentially lucrative because of the size of transactions that can be acquired. Working on a $10 million transaction requires the same amount of work as working on a $40 million-dollar deal in the same asset class, and yet the risk-return profile may remain the same.
The nature of the tenants themselves is another important element to consider in choosing between residential and commercial real estate investing – some sponsors simply cannot imagine their tenants actually living in their buildings. These sponsors will prefer industrial or office or retail assets over apartments or hospitality, for example. An apartment specialist will thrive on the idea that everyone needs a place to live, even during an economic downturn, and that one vacancy in a 100 unit building is only a 1% vacancy, whereas the vacancy caused by a single tenant or very large tenant in an office or industrial property could cause the collapse of the financial structure of the project and the loss of all equity invested.
Why Residential Real Estate?
As stated previously, if anyone is thinking about buying property and getting into real estate investing, residential real estate property is the way to go if that investor wishes to retain all control and management of their investment. Furthermore, buying residential real estate in the form of single-family homes has largely become commoditized, with websites offering one-click purchasing opportunities. Financing residential purchases for investment purposes is also a relatively simple process, with investing basics like an appraisal from the bank, some steady primary income, and a good credit score.
In a good economy, home prices, particularly in some states, seemingly acquire a never-ending upward trajectory which also lends itself to the apparently quick and easy route to fortune in property investments. Fixing and flipping are a surefire way for home investors to boost their funds. When times are good, this is a great way to make money in real estate investment with little more effort than just a coat of paint and some new carpets to add value to a property. That said, this kind of real estate investing always does well, until it doesn’t, and when cycles turn, as they always do, the last person holding investment homes is the one most likely to lose their shirt.
Another distinct advantage of investing in residential real estate over commercial is that local zoning laws can often be clearer cut. Any developer will tell you about the infamous call that often comes through on a property… it doesn’t have the proper zoning. In residential zoning, other regulations have to be considered, but the kinds of rules and restrictions are generally easier to navigate than commercial property restrictions. With an ever-changing economy and huge inflation rates, having the freedom and ability to change the terms on a lease in a shorter period, is no small detail to consider in an investment choice.
Another major factor that may seem obvious and is always something to keep in mind: need. People will always need a place to live, and capitalizing on this will make for a steady stream of return on investment for the residential investor who carefully mitigates risk and who plans for the inevitability of a downturn.
What Are Commercial Loan Interest Rates?
The range of types of debt a commercial real estate project can access is generally broader than those offered a residential investor. Commercial real estate loans come in different shapes and sizes, and the interest rates payable vary according to the amount of risk the lender is willing to take.
The lowest risk capital commanding the lowest interest rates is that which is said to be in the first position – meaning the first to be paid out when a building is sold. A financial institution like a bank most often supplies this. The next least risky investment is that kind of loan that is said to ‘sit on top of’ the first position loan. This is the appropriately named ‘second position’ loan although these kinds of loans became less frequent since the global financial crisis of 2007-08, they would charge higher interest rates than the first position bank because they are only paid off once the bank has returned all monies due.
Demanding higher interest rates are those kinds of loans that are subordinate to first and second position debt. This can come in the form of mezzanine debt, which, as its name implies, sits between two strata of finance. These are debt and equity, or preferred equity. As its name suggests, preferred equity is superior to common equity for real estate investors – common equity being the layer of capital in which most investors participate.
What Are Residential Loan Interest Rates?
There are different types of residential loans also, but there are fewer varieties, and the term of the loan largely drives those that do exist before maturity and borrower credit score than by position in the capital stack.
Interest rates will vary accordingly. A shorter-term loan will typically carry with it a lower interest rate than a longer-term loan but offer greater vulnerability to market cycles accordingly. A residential real estate investor’s best scenario when it comes to interest rates is to balance the term with which they intend to hold a property, with the type of loan they acquire, while keeping a careful watch on the market cycle. No matter what kind of loan the residential investor takes on board, and this applies equally to the commercial investor, ensuring that debt repayment does not exceed net operating income is critical.
Real estate, as we like to say at Trion, is not the killer in real estate. Debt is, and getting too deep into debt without planning on how to survive a dip in income due to recessionary forces is a sure way to lose your investment.
Is Commercial or Residential Real Estate Investing Better for Passive Income?
Passive income in real estate is the absolute ideal for any real estate investor. Everyone buying property wants an investment that requires little to no effort put into by the investor while still yielding a steady source of income. For investors looking to diversify their assets away from stocks and bonds to supplement their regular income, real estate offers a time-proven alternative.
Both commercial and residential real estate can yield passive income, but the distinction comes in refining your definition of ‘passive.’ In truth, the distinction is one conjured up by the taxman – ‘passive’ income is treated differently than ‘earned’ income or ‘capital gains.’ In reality, while ‘passive’ income can come from owning residential real estate directly or investing as a partner with a seasoned developer, the distinction is in how active or passive you want to be on a day-to-day basis.
The IRS will still tax you on the ‘passive’ income you earn from renting out a single-family home to someone, while you, very actively, maintain and manage the property. Similarly, you can earn ‘passive income’ while truly doing nothing when you invest with a seasoned developer who does all the work for you, like those at Trion – but they will be investing in commercial real estate and therein lies the difference.
Is Commercial or Real Estate Investing Right for You?
The correct decision when it comes to real estate investment depends on the investor. Each investor can only know what their financial bandwidth and ability to take risks ultimately looks like, and how much work they want to put in on a daily basis. Only they are the ones that can honestly understand what they can take on, and every investor knows what kind of traits and energy expenditure they must employ to be most beneficial for them and their families.
If you don’t mind doing the daily labor of maintaining and managing real estate while retaining control of all aspects of your investment, then residential investing could be a good option. If you prefer to let the pros do all the work, while you get on with your daily routine, and don’t mind relinquishing control to someone else as you do when you invest in the stock of a company, then investing in commercial real estate with a seasoned developer is a great option.
Either way, balancing risk with return and never investing more than you can afford to lose is a great way to get started in real estate investing, no matter what kind of real estate you begin with. Contact Trion Properties to see how our private equity firm offers unrivaled real estate assistance and learn about our team.
Related: What is Trion’s Investment Strategy?