For the investor looking to build wealth over the long term, save for retirement, or simply achieve a greater level of financial freedom, real estate, whether residential or commercial, offers ample opportunity to do exactly that.
Real estate will diversify your portfolio and offer considerable tax benefits, but when it comes to investing in residential versus commercial properties, which is the right strategy for you and your goals?
Some investors already experienced with residential properties may be interested in expanding to commercial real estate (CRE), while those new to real estate may be wondering where to begin: with residential properties, commercial or both?
Consider your short- and long-term goals. For a faster return on a small-scale, residential properties may be the way to go. If you’re committed to long-term growth with potentially higher returns, the benefits of commercial real estate may be right for you.
Like any investment, real estate comes with its own set of risks and rewards, and commercial real estate differs significantly from residential in its strategies, financing, and acquisition.
Understanding the pros and cons of commercial real estate will help you decide if it’s a good fit for your investment strategy.
What is Commercial Real Estate?
Commercial real estate is a property with five or more units used specifically for business or income-generating purposes. This may include multifamily housing, hotels, office, retail, restaurant, industrial, warehouse, healthcare, or multi-use spaces.
While families or individuals are the typical tenants in a residential property, commercial properties are leased by businesses and corporations. Depending on their location, commercial properties may be subject to more complex zoning ordinances than residential units.
Investing in Commercial Real Estate: Pros
Commercial real estate offers investors a specific set of benefits and opportunities that differ from residential properties. Does that make commercial real estate a better investment? It depends on what you’re looking to achieve, but consider the following advantages to commercial real estate:
High return potential
Commercial properties historically see a much higher average annual cash flow and return on investment than residential properties. Annual returns range between 6% and 12% (compared to the residential average of 1% to 4%). A report from the National Council of Real Estate Investment Fiduciaries (NCREIF) indicates a 25-year average return of 9.4% for privately held commercial real estate, which is just slightly under the S&P 500 average of 9.8%.
Commercial real estate is entitled to tax breaks that can significantly reduce the tax burden on commercial property. These may include deductions for mortgage interest, depreciation, and non-mortgage-related expenses such as maintenance, renovations, or association fees.
Plus, with 1031 exchanges, you may be able to avoid capital gains tax when you sell your commercial property if you reinvest those profits into another building or asset. A tax professional can help you navigate the finer points of using a 1031 exchange strategy.
Residential owners with single- or multi-family properties often invest a considerable amount of time and effort in vetting high-quality tenants who can be trusted to care for the property as if it were their own.
Commercial tenants are businesses or corporations who have a vested interest in maintaining a professional public image and are thus more likely to take the care and maintenance of the property seriously to protect their business and their brand. The relationship between a business leasing commercial space and the property owner tends to be professional, based on a business-to-business alignment.
Triple net leases
Many commercial properties operate using a triple net lease, an agreement in which the lessee pays the property taxes, insurance, and maintenance on the building, leaving the property owner responsible only for the mortgage.
Commercial leases also tend to be much longer, anywhere from 2 to 10 years, compared to shorter 6- to 12-month residential leases, meaning there’s less turnover and fewer vacancies to deal with in commercial leases.
Revenue increases valuation
Residential real estate derives its value from comparable properties in the same area (comps), but the value of a commercial property is based upon its ability to generate revenue. Higher cash flow equates to a higher valuation, meaning a commercial property’s profitability could increase quickly with the right tenants.
Investing in Commercial Real Estate: Cons
Professional services required
Managing one or more commercial properties each with multiple tenants is akin to running a small business. There’s more to manage, more maintenance, and more public safety concerns. A professional management company stays on top of issues to keep things running smoothly and tenants happy.
Commercial zoning has multiple categories, and regulations tend to be more complex than residential zoning requirements. A thorough understanding of local zoning ordinances is required to remain compliant.
Large upfront investment
More upfront capital is required to purchase a commercial property, and with it comes bigger maintenance and upkeep costs. Replacing the roof or the HVAC system of commercial property for example is far more costly than the same repairs on a residential property. Having a capital reserve and contingency fund is a must.
Getting started with commercial real estate
Investors who have done their due diligence and feel ready to test the commercial real estate waters should first make sure they’re working with a real estate professional who is knowledgeable and experienced in commercial real estate.
While the hefty upfront cash investment can be out of reach for some investors, there are more passive options to investing in commercial real estate without outright purchasing properties.
Peer-to-peer real estate crowdfunding allows you to pool your money with other investors and the ability to open a portfolio with a much smaller initial investment.
Similarly, REITs (Real Estate Investment Trusts) describe a company that invests in a portfolio of real estate projects and distributes earnings to its shareholders. There are several types of REITs: publicly traded, publicly non-traded, and private, each with its own set of regulations. While REITs are a hands-off way to invest in commercial properties, investors have less control over the types of properties invested in or when they can access their money.
While the high-risk/high-reward nature of commercial real estate might not be right for all investors, remaining open to considering new property types expands your options and could help you reach your financial goals.