Let's Look Closely At Residential Income Property VS. Commercial

So far this year I’ve had this particular conversation maybe half a dozen times. I’ll have a few more. It comes with its own script. They either want to explore the acquisition of some sorta retail or office property, or have one and wanna talk about how fast I can get ’em out of it.

The former should talk with the latter before they call me, as it sure would save a lotta time. 🙂

The callers usually own some residential income property. Sometimes it’s relatively largish apartment complexes. They’ve been seduced by the easier management, higher tenant quality myth. They love the whole long term lease concept. Longing for the office and/or retail setup with a buncha 3-10 year leases, turns them into starstruck high school cheerleaders ogling the latest king-of-the-hill quarterback as he struts by with his trailing entourage. They don’t realize that 99% of those QB studs end up five years later workin’ for their best friend’s dad’s construction company cuz they couldn’t cut it in college when the rubber hit the asphalt.

Then there are the first time investors who wanna take a whack at the local strip mall, or smallish office building near where they work. They have a couple partners, ‘did the numbers’, and think they’ve found Nirvana.

It’s never pretty as I slowly, gently as possible, burst their bubbles with the cold, hard, facts of life.

Generally speaking, office and retail properties suck like turbo charged Dysons when compared directly, over the long haul, with residential income property.

I’ve invested in them, rehabbed them, and watched countless others do the same. Unless (and this is my own personal opinion) you’re in to make a quick profit, in and out, using the greater sucker theory (so to speak), avoid them like the plague.

That said, I know my view on this topic will engender all sorts of investors with their own success stories about the dream office or retail property. Save it for someone else, OK? Please? Over the long haul, the following will happen to you — or it already has, but you’re never gonna ‘fess up to it. Also, to each their own, whatever works for ya is what you should be doin’. Those who own the perpetually high demand commercial space in the ‘to die for’ locations are the exceptions proving the rule.

When the economic cycle hits the downside, very few real estate investment property types make it through unscathed, commercial OR residential. The problem with your office or retail property is a simple one. Take now, for instance.

Spoke with a guy from my market last week about the travails his office building is puttin’ him through. Before he began in earnest, I told him what he was facing — and it’s something residential income property owners don’t face. (Unless, that is, your one of those who fell for the ‘super high cap rate properties in the worst area’ con.)

He could, literally, give a couple of his now former tenants a dime a foot to stay put, and they still wouldn’t be able to stay in business.

On the other hand, the employees of those now defunct businesses are goin’ home to my apartment building, casting their net on the waters lookin’ for a new job and/or a roommate to help with the rent. Either way, I still have a tenant. They move out? So what? It’s an inconvenience the office building owner would love to have inflicted on him. Remember, in poor economic times, many tenants would still go bankrupt being paid to take up space in your office/retail building. 🙂

Even if tough times impact rents downward, (which, of course they will at one point or another) again I say, so what? I’d rather take a 10-30% drop in rents temporarily than have my building 50% vacant for 6-18 months — or more. Think that’s to harsh? As anyone who owned ‘can’t miss’ commercial property in the early 80’s or 90’s. You’ll hear war stories that’ll curl your hair.

As one caller was trying, in vain, to defend his decision opting for an office building over (his words) boring ‘rentals’, I turned all Dr. Phil on him, asking quietly — “So, how’s that been workin’ out for ya lately?”

Crickets.

He’s owned this property for eight years. Even after the correction, his equity position is currently about 25%, maybe more. He’s now losing approximately $1,000 a month. He can afford it, but who wants to, right?

Meanwhile, those who went for the vanilla, no chocolate sauce, smallish residential income properties?

They’re cash flowing to the tune of 3-12% cash on cash with just 20% down payments. They’ll make it through this down time with increased equity, regardless of the appreciation — now a complete non-factor. Furthermore, they’ll reach the finish line, (we call it retirement) with debt free properties spinnin’ off stable incomes from folks who must have a place to live. Compare that to much of business, which may or may not need an office or a store — or be able to afford one even if they desperately need it. Go figure.

Also, and a very critical consideration, is the twin lines of the buyer pool and financing for residential income property vs their commercial cousins.

For every buyer the commercial owner attracts, I’ll have at least a dozen, if not more — many more. Combine that with lower interest rates and longer amortization periods ceded to residential income properties. You end up with an attractive cash on cash return while using 50-100% less capital up front. Thinkin’ the one with ten times the buyers, better loan terms, and significantly lower entrance requirements is for me.

Wanna know why so many investors band together when buyin’ multi-million dollar small to midsize office or retail properties? So they can buy ’em for cash. They know what I’m sayin’ here is true, and simply don’t wanna risk the potential disaster of huge and long term vacancies with the added burden of debt.

They know exactly what they’re doing. Their strategy can be defined as preemptively defensive, pure and simple.

The NNN deal on a building with a AAA location to die for, and the AAAAA killer tenant is maybe .1% of the office/retail market, people.

Those impressive stats we see thrown around — almost always projections — at least partially if not completely so, come to naught when the double digit cash on cash percentage turns to dead presidents flowin’ outa your own Levi’s when bad times come a knockin’. I’ve often compared office/retail properties to Wall Street. They go way up, they come way down, and only the huge players come out OK — and even then not nearly all the time.

Residential income?

We’re presently generating just over 10% cash on cash with 20% down payments for small 2-4 unit income properties. Is that impressive return gonna last? No way. But those who buy today will have the historically low fixed interest rates tomorrow. Their tenants must find a way to pay rent even in bad times, or we find someone else who prefers brick ‘n mortar over the back seat of their SUV.

Why would an investor with hard earned capital to invest, choose an office or retail building on purpose?

It’s always been a mystery to me. I’ve been there, done that –gave it several tries. Made money on the 6-24 month turn and burns — broke even or lost money on the buy and holds.

The deck is stacked in favor of the residential income property investor — even more so in the long run.

But again — to each their own. If it’s workin’ for you? Good on ya. I’ll never own one again, and my clients won’t have one through me, with very rare exceptions.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.