Investing in real estate with commercial or residential properties can be a great way to grow your money. Commercial and residential real estate investments are very different and it takes time to learn the ins and outs of each. Commercial real estate may be a great investment for some, but I think residential real estate is an easier investment to understand. But if an investor is well versed in commercial and willing to work hard, you can make a lot of money with commercial real estate as well. I invest in residential properties and commercial properties.
Why did I start investing in residential rental properties and not commercial rental properties?
I have 20 long-term rental properties, and they have been great investments with great cash flow. Not only do my rental properties provide over $100,000 a year in cash flow, they also have increased my net worth by $600,000 in the last 3.5 years. My first 16 rentals were residential properties, but I switched to commercial for my last purchases.
One reason I like residential rental properties is I am a real estate agent who specializes in residential properties. Because I deal with residential properties all day long, I know residential rentals better than I know commercial rentals. I know how to buy residential properties below market value and I know my rental market very well. I also invest in residential properties because in my area residential rental properties tend to give better returns than commercial rental properties.
Are residential rental properties easier to understand than commercial rentals?
Buying a residential rental property is pretty simple once you learn your sales and rental markets. You need to know how much the house costs, what it will cost to repair, what it will be worth and what it will rent for. Even though residential rental properties can be simple, it still takes time to learn how to invest in them and make money.
Commercial properties, on the other hand, are much more complicated than residential rental properties. With commercial rental properties you need to know the same things as you do with residential rental properties, but figuring out those numbers is much more difficult. Factors that affect rent and value are the type of tenant that best suits your building, how long a lease is, how solid your tenant is and the future desirability of your building. All of this is important with residential, but much more so with commercial. The reason these factors are more important with commercial is they have a huge impact on the value of the property where a single-family residential property is valued off the demand of owner-occupied buyers.
How are commercial properties valued differently than residential?
Valuing a residential property is done by determining what other similar properties are selling for. Many more residential properties sell than commercial properties, and it is usually pretty easy to find sold residential properties that are similar to a house you own or are looking to buy. Valuing residential properties based on the sales of other residential properties is called the sales comparison approach.
Commercial properties are rarely valued using the comparison approach because there are much fewer commercial properties and it is hard to find similar properties that have sold recently. Most commercial properties are valued using the income approach, which is much more complicated than the sales comparison approach.
What is the income approach when valuing commercial properties?
The income approach uses the income a property generates to value a property. Most commercial properties are valued this way as well as some multifamily residential properties.
The income approach takes the profit a property makes per year and multiplies it by a cap rate to come up with the property’s value. I wrote a much more detailed article on cap rates here. The cap rate is not a set figure but varies in different parts of the country and for different types of properties. When you are buying commercial properties, it is very important to know the market cap rates.
Why does the cap rate on commercial properties change?
If you have a 20,000 square foot warehouse leased for 10 years to a tenant with almost no risk of default, that cap rate will be different from an office building that is half vacant with mediocre tenants in the other half.
The cap rate will be lower for the property with the stable tenant because that tenant has a better chance of paying rent through his lease term and the lease is longer. The office building will have a higher cap rate because there is much more risk involved and it will take work to rent the vacant spaces. Cap rates will vary based on the type of tenant, the length of the lease, the credit rating of the tenant, the condition of the property and market conditions.
Commercial properties are much harder to value than residential properties
As you can see, valuing commercial rental properties can be very difficult. You must know the market cap rates for a building, a tenant, and your market. These cap rates are not always easy to figure if you are not very experienced in the commercial real estate market. If you overpay for a commercial building, it could be very hard to ever sell or refinance if needed. Properties that look like an awesome deal may be priced low due to a bad tenant or an uncertain future.
The other problem with valuing properties off the income approach is you are using information from the current owners for expenses and income. If the owner fudges his numbers or forgets a few expenses, the property will look much more valuable than it really is.
Residential properties are usually more stable in a down market
Everybody needs a place to live, but not everyone needs a store or wants to own a commercial investment property. Another reason residential properties are safer than commercial properties is there will always be a larger buyer pool for residential properties. Even when the market is bad people will buy houses or rent houses because they need a place to live.
In the commercial market, people may close their shops, work at home or get another job if the market turns bad. Commercial real estate investors may have trouble getting a commercial loan and will not buy in a down market. This means that it may be incredibly difficult to sell a commercial property in a down market; especially if it is vacant. In a down market, you may have to rent or sell a residential property for less money, but you may not be able to sell or rent a commercial property at all.
Commercial properties typically have much longer leases than residential rentals
Longer leases can be a good thing for investors, but there is a reason commercial leases are longer. Commercial properties typically take longer to rent and are harder to rent than residential properties. Landlords want a longer lease in place on commercial properties, because of the difficulty in leasing commercial. When a commercial property goes vacant, it can stay vacant for months or even years. This is also why the cap rate varies so much with commercial. An investor has to consider how long the current lease is and how stable the current tenant is. A ten-year lease is great, but even ten-year tenants can go bankrupt and you are left with a vacant building. Since commercial buildings are usually very specific to the tenant, it could take a long time to lease or a lot of work to retrofit a building for a new tenant.
Commercial leases are much more complicated than residential leases
A commercial lease is not a straight one year lease with the tenant paying utilities and no pets. A commercial tenant has many lease options; a gross lease, triple net, double net, modified gross etc. The explanations for the different types of leases can be found here. The cap rates will change again based on the types of lease and what costs the tenant is paying.
Financing a commercial property is much different from a residential property
It can be difficult financing residential properties, but there are many lenders who will loan on them. Typically you can get 15-year or 30-year loan on residential rental properties. With commercial properties, the loan amortization is going to be lower than 30 years and most commercial loans will have a balloon payment. A balloon payment means the entire balance of the loan will come due after a certain amount of time like 5 or 10 years. The investor must pay off the loan when the balloon payment comes due, which is not always easy. Many commercial investors count on being able to refinance their loans when a balloon payment is coming due, but that is not always possible. If the lending market becomes tighter, an investor’s financials change or the commercial market changes, it may not be possible to refinance.
What opportunities are there in commercial real estate?
Even though commercial real estate can be a very tricky business to be in, there is an opportunity to make a lot of money. There is no black and white valuations of commercial properties because there are so many factors to consider with cap rates. That means the people who really know what they are doing can spot good deals or a way to increase the cap rates on properties. If you have a property that is worth $200,000 based on a 10% cap rate, that means it is generating $20,000 a year in income. If you can create a more stable lease or rent to more attractive tenants that could lower the cap rate, that makes the property more valuable. If the property was generating $20,000 a year income and had an 8 percent cap rate it would be worth $250,000.
An investor could also find a better use for a commercial building, which may increase the income or lower the cap rate. A warehouse may not have a good cap rate in a certain market, because there are vacant warehouses all over. That warehouse could be turned into self storage, which is in short supply increasing the income and lowering the cap rate. Increasing the value of a commercial property could be as simple as taking a vacant building and finding a good tenant on a long-term lease.
For most investors, residential properties are much simpler and easier to understand than commercial properties. It takes a lot of time and experience to understand the commercial world and how it works in the market you want to buy in. I currently stay away from commercial properties, but I won’t rule out investing in them in the future. The most attractive part of commercial investing to me would be increasing the value of properties and quickly turning them like my residential fix and flips. There are so many unknowns with long-term commercial properties because lending can change, financing terms are different and the vacancies can last a long time.
When I wrote this article I had not bought any commercial properties. I have bought multiple properties in the last year. Commercial real estate is very complicated, but I have learned a ton over the last couple of years.