Investing in real estate remains a popular avenue for wealth creation, but it’s not a one-size-fits-all venture. There are fundamental differences between commercial and residential real estate investing, and each has unique advantages and challenges that cater to different investor profiles.
Understanding these distinctions is important for aligning your real estate investment with your financial goals and risk appetite.
Key Takeaways
- Real estate investors typically have the choice to select between commercial and residential properties.
- Commercial properties involve tenants that are businesses or multifamily apartments with five or more units.
- Residential properties are those where people live, such as single-family homes, duplexes, triplexes, or apartment buildings with four or fewer units.
- Each category has its own unique risks and potential rewards.
What Is Commercial Real Estate Investing?
Commercial real estate involves properties used for business purposes, such as offices, retail spaces, warehouses, and apartment buildings with five or more rental units. Investors in commercial real estate earn income by leasing spaces to businesses, which can compare better to residential units because of longer lease agreements, higher rental yields, and more significant appreciation. However, this sector usually demands higher initial investments, involves more complex management, and is more sensitive to economic fluctuations.
Pros and Cons of Commercial Real Estate Investing
Pros
Higher earning potential because of higher rental yields
Longer lease agreements provide stable, long-term income
Potential for significant property appreciation
Can arrange net lease for tenant to pay taxes, insurance, and utilities
Cons
Higher initial investment and ongoing costs
More complex property management
Greater sensitivity to economic cycles
What Is Residential Real Estate Investing?
Residential real estate investing focuses on properties designed for living, such as single-family homes, condominiums, and small apartment buildings (with four or fewer units).
These investments typically require lower initial capital and are more manageable to maintain and operate. Residential properties tend to have shorter lease terms (e.g., yearly), providing more flexibility but faster tenant turnover.
Pros and Cons of Residential Real Estate Investing
Pros
More accessible and affordable for new and individual investors
Generates rental income and potential for long-term appreciation
Typically easier to finance and manage
Cons
Smaller rental yields compared with commercial properties
Higher tenant turnover and vacancy risks
Dealing with tenants can be difficult
Commercial vs. Residential Real Estate Investing: Returns and Risks
Commercial real estate investing typically offers higher returns than residential investments. This is primarily because of higher rental yields, a product of longer lease agreements, and the ability to charge businesses more than individual tenants. Also, commercial properties can appreciate significantly in value, especially in thriving economic areas or growing cities.
However, these higher returns meet with heightened risks. Commercial properties are more susceptible to economic downturns since businesses are more likely to cut costs, including real estate expenses, during tough economic times. In addition, the initial investment and ongoing operational costs are generally higher in commercial real estate, requiring a more substantial capital outlay and potentially increasing financial exposure.
A notable aspect of commercial real estate that affects returns and risks is the prevalence of net leases. Unlike the typical lease structure in residential properties, where the landlord bears most property expenses, commercial leases often shift a part or all these expenses to the tenant. There are three main types of net leases: single, double, and triple.
- Single net lease: The tenant handles paying property taxes and rent. The landlord covers all other expenses.
- Double net lease: The tenant pays property taxes, insurance premiums, and rent. The landlord takes care of maintenance costs.
- Triple net lease: This type shifts the most costs to the tenant, requiring them to pay property taxes, insurance, and maintenance costs on top of their rent. This type of lease significantly reduces the financial burden on the property owner.
The type of net lease involved in a commercial real estate transaction can greatly influence the return on investment. These leases can lead to a more stable and predictable cash flow for the landlord, as the variability and unpredictability of certain expenses are transferred to the tenant. However, the attractiveness of a property to potential tenants can be affected by these additional financial responsibilities, which might increase vacancy risk.
Meanwhile, residential real estate, while offering potentially lower returns, has more stability and is ordinarily seen as a safer investment, especially for first-time and individual investors. The market for residential properties tends to be more resilient during economic downturns, as the demand for housing remains relatively constant. However, the risks in residential real estate include higher tenant turnover, which can lead to variable income, as well as ongoing property maintenance and management needs.
| Comparing Commercial vs. Residential Real Estate Risks and Rewards | ||
|---|---|---|
| Factor | Commercial Real Estate | Residential Real Estate |
| Average Returns | Higher rental yields due to longer leases and business tenancies. Potential for significant property appreciation. | Lower rental yields but steady income from shorter leases. Consistent long-term appreciation. |
| Initial Investment | Higher due to property scale and location. | Lower, making it more accessible for individual investors. |
| Operational Costs | Higher, including maintenance, property management, and customization for tenants. | Relatively lower and more manageable. |
| Market Sensitivity | Higher sensitivity to economic cycles and business demand. | Less sensitive, with more stable demand. |
| Tenant Turnover | Lower turnover due to longer lease agreements. | Higher turnover with shorter lease terms. |
| Risk Profile | Higher risk, with potential for greater returns. | Lower risk, offering stable and consistent returns. |
| Accessibility for New Investors | Less accessible due to higher capital requirements and complex management. | More accessible, with lower capital requirements and simpler management. |
| Lease Structure | Net leases common (single, double, triple), transferring more expenses to tenants. | Gross leases are prevalent, with the landlord covering most expenses. |
Choosing Between Commercial and Residential Real Estate Investments
Whether to invest in commercial or residential real estate is a significant decision that hinges on your financial resources, investment goals, risk tolerance, and expertise. Here’s an expanded look at these considerations:
Financial Resources and Initial Investment
Commercial real estate typically requires a higher initial investment compared with residential properties. This includes not just the purchase price but also potential renovations, legal fees, and a buffer for initial vacancy periods. Commercial assets can cost millions more upfront than typical residential rentals because of their scale and development expenses.
It’s crucial for investors to assess their financial capability and access to capital. Residential properties, meanwhile, are more accessible to a broader range of investors, including those with limited capital, because of generally lower entry costs.
Investment Goals and Time Horizon
If your objective is to generate a higher income in the short term, commercial real estate might be more suitable, given net leases and its potential for higher rental yields. However, if you’re looking for long-term wealth accumulation with a steady income, residential real estate can be a more attractive option because of its potential for consistent rental income and property value appreciation over time.
Risk Tolerance
Commercial real estate is usually more sensitive to economic cycles. So, while it can offer higher potential returns, it also comes with higher risks, such as longer vacancy periods and more significant impact from market downturns as businesses scale back and may close certain locations.
Residential real estate typically offers more stability, making it a relatively safer choice for investors with a lower risk tolerance. Even during a recession, people need a place to live. Your decision should align with how comfortable you are with potential income and property value fluctuations.
Level of Expertise and Management Requirements
Managing commercial properties requires more expertise and sophistication because of the complexities of commercial leases, tax implications, property management, and business tenants’ particular needs. Residential properties are generally easier to manage, especially for those new to real estate investing.
If you lack experience in managing commercial properties, it would be prudent to consider a property management company, which comes at a cost but can minimize future issues.
Market Research and Location
Both types of investments require thorough market research, but the criteria differ. For commercial real estate, understanding the local business environment, commercial property demand, and economic forecasts are crucial. Residential real estate investment decisions are more influenced by neighborhood quality, schools, local amenities, and overall housing market trends.
Liquidity Considerations
Commercial properties typically have a smaller pool of potential buyers, which can affect liquidity (the ability to sell quickly for a fair price). Selling a commercial property might take longer than a residential one, which is important if you anticipate a need to liquidate your investment quickly.
Tax Implications
Both types of investments offer different tax benefits and implications. Commercial properties, for example, are typically depreciated over a longer period (usually 39 years in the United States) than residential properties (27.5 years).
This extended timeline can mean smaller annual tax deductions. Capital gains tax applies when a commercial property is sold for a profit. Like commercial properties, selling residential properties at a profit can incur capital gains taxes. However, if the property was used as a primary residence for at least two of the five years before the sale, up to $250,000 (or $500,000 for married couples) of the gain can be exempted.
Typically, residential properties have lower property tax rates than commercial properties. However, some jurisdictions offer tax incentives for commercial property investments, such as reduced rates or credits for developing in certain areas or for specific types of tenants, to attract new businesses.
It’s advisable to consult with a tax professional to understand how investing in commercial vs. residential real estate will impact your tax situation.
Commercial and residential real estate buyers can use the 1031 exchange provision, which allows them to defer capital gains taxes by using the proceeds from the sale of a property to purchase another like-kind property.
Example of Commercial vs. Residential Real Estate Investing: A Case Study
Sarah is deciding whether to invest $1 million into a four-unit multifamily apartment building (a residential property) or a small suburban office building (a commercial property).
The apartment complex would generate around $300,000 in gross annual rent with expected expenses of 30%, resulting in $210,000 net operating income (NOI). With an average apartment capitalization rate of about 5%, the asset would be valued at about $4.20 million.
The suburban office building has an asking price of $2 million. Its 10,000 square feet could command an average rent of $30 per square foot, providing $300,000 in potential gross annual rent. Since the expenses are about 50% for commercial properties, Sarah expects $150,000 NOI. Since commercial cap rates average about 7%, this indicates a valuation of $2.14 million.
Over five years, Sarah expects the apartments to appreciate at an average of 3% per year, in line with historical trends. Her initial $1 million investment would grow to $1.16 million. Adding in the estimated NOI of $1.05 million over the five years gives her a $2.21 million total return on investment.
The commercial building’s value is forecast to rise more quickly, averaging 5% yearly based on projected job growth and the demand for office space. Her $2 million asset could grow to $2.55 million in five years. With $750,000 total NOI projections over the five years, returns would total $3.30 million.
However, office buildings also have a higher vacancy risk than apartments in this smaller market. If vacancy rates spike to 25% in a weak economy, Sarah’s NOI drops by $75,000 per year. Over five years, that creates almost $400,000 less in rental income, or about $2.90 million in total returns. By contrast, apartments might only have a 5% drop in occupancy with far less lost in rent. The more consistent residential income stream offsets slower appreciation.
So, while commercial promises higher returns, residential delivers lower risk and more stable occupancies. Investors like Sarah must weigh these risk-return tradeoffs against their goals.
If possible, don’t concentrate all your real estate investments in one region. Different areas can experience unique economic and property market cycles, so spreading your investments can mitigate location-specific risks.
Other Considerations
Every real estate investor approaches the market with different financial goals, timelines, experience levels, and personal risk comfort ranges. Determining investment priorities upfront enables tailored strategies best suited for an individual’s unique objectives and constraints.
One approach to capturing the benefits from each type of property is to diversify among both residential and commercial properties. As with other types of portfolios, diversification in real estate means spreading your investments across different types of properties and locations. This strategy reduces risk because different real estate segments often perform differently under the same economic conditions.
The allocation between commercial and residential real estate should reflect your risk tolerance, investment goals, and market conditions. For instance, if you seek higher income potential and can handle more risk, you might lean toward a heavier weight in commercial properties. If you prefer more stability and easier management, residential properties might represent more of your real estate holdings.
Alternatively, you can also diversify by how you invest in real estate. Real estate investment trusts (REITs) own, manage, or lend money for real estate. When you invest in a REIT, you get shares in a trust with a portfolio of properties. REITs offer greater liquidity, and most are traded on the major stock exchanges. They must also distribute at least 90% of their taxable income to shareholders.
Is Commercial or Residential Real Estate a Better Investment?
There is no universally “better” real estate investment. Commercial properties offer higher profit potential but require heavy capital and expertise. Residential rentals serve as an accessible entry point with lower risks.
Investors must evaluate options and strategies based on their situation and long-term goals.
What Are the Categories of Commercial Real Estate?
The main property types that fall under commercial real estate besides office, retail, and industrial spaces are hotels, restaurants, self-storage facilities, data centers, cellphone towers, housing for older adults, student housing, medical offices, manufactured-home communities, and multifamily apartment buildings with over four units. Each sub-sector has unique risk-return drivers for investors to research before investing.
What Types of Residential Properties Should a Beginning Real Estate Investor Target?
Beginning residential real estate investors generally do better starting out with smaller multifamily properties of two to four units, like duplexes, triplexes, and small apartment buildings. Each of these offers a certain degree of affordability, consistent cash flow, and rental demand with less intensive maintenance than large single-family rentals. New investors should also consider getting a real estate license to save on fees before their portfolio grows.
What Are the Differences Between Residential and Commercial REITs?
REITs expose investors to real estate assets without having to buy, manage, or finance properties directly. Their shares trade like stocks on exchanges, allowing ordinary investors to access real estate portfolios indirectly.
Residential REITs invest in rental housing like apartment buildings, single-family rental homes, student housing, and older adult residences. They earn revenue primarily through rental income from occupants. Commercial REITs invest in properties leased to retail, office, industrial, and other business tenants. Revenue comes mostly from business lease agreements.
Can I Invest in Both Commercial and Residential Real Estate?
Yes. Combining both commercial and residential investments enables real estate investors to build a diversified portfolio that takes advantage of the stability of residential alongside the higher income potential of commercial.
The Bottom Line
Deciding between commercial and residential real estate investing hinges on understanding their unique characteristics and how they align with your investment objectives. While commercial real estate promises higher earning potential, the substantial capital and management expertise required make it prohibitive for many individual investors. The stability and accessibility of residential rentals offer a more feasible starting point to gain experience and slowly expand into commercial properties over time.
Investors should carefully weigh their available resources and expertise against expected returns and risks when deciding between commercial and residential real estate investing.
Article Sources
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in oureditorial policy.
Ron Forlee, via Wiley. “Real Estate Development Strategy for Investors,” Pages 1–39. John Wiley & Sons, 2022.
Internal Revenue Service. “Publication 527 (2022), Residential Rental Property.”
U.S. Securities and Exchange Commission. “Investor Bulletin: Real Estate Investment Trusts (REITs).”
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