residential vs commercial

12 Replies

Dear BPers,

I've noticed that this site seems really focused on residential real estate investing. I'm curious why there seems to be an emphasis in that direction here. My impression (though I am definitely a novice about REI) is that commercial has fewer hassles--and cash flows as well. But maybe I'm missing something.

Any thoughts on pros and cons between residential vs commercial would be appreciated.

Sincerely, 

Tom J.

I think in general people are more comfortable with residential.  Most people understand it more because they either have been renters, or they own a house as a primary residence.  Another benefit of residential is that there are lower barriers to entry (at least in most parts of the country).

However, I tend to agree with you that commercial tends to have less hassles and better cash flow.  I like with commercial that you are able to have a more direct influence over the property's value, the tenants are businesses (except for apartments which are technically commercial) and therefore you generally only have calls from your tenants during business hours, and hopefully there is less wear and tear on your investment.

Residential just has a lower barrier to entry, lower purchase price, easier lending, etc.

Commercial is where I put my money though.

You’re on the right track in my opinion. Most residential investors graduate into commercial once they realize the time and expenses in managing all these separate properties. Think of it like this, would you rather own 80 single family homes or two shopping centers with national tenants paying all the expenses and any increases in taxes and insurance. I know which one I would choose.

As others have eluded to, residential has lower barriers to entry, especially in today's market. The barriers aren't just financial, however. If you're going to invest a large amount of money into a commercial investment, you better know the market and industry very, very well. You can't just buy a Starbucks, for example, and not know a thing about the coffee industry (or food service in general). It's more than just buying a nice looking property in a nice area, many factors at play.

Not only that, the risks to commercial are usually greater. If you get a vacancy in a residential, it's usually easier to fill (everyone needs a place to  live). If you lose a commercial tenant, it can be difficult to replace them. If you have a nationally recognized tenant, the risk of default is usually low, but you never know what might happen in today's world. 

Tons of variables at play. I review about a thousand properties a week for retail. Just like anything you have to buy right.

There are different types of commercial.

There is the mom and pop type retail condo's, street old town retail,etc. at cheaper price points maybe 1 million and under. Then when you go up in range you can start running into national credit tenants. Typically most properties under 2 million sell for cash STNL. There are some exceptions such as Dollar stores where you can buy at a 7 cap and have debt at a 5 rate for 200 basis point spread. Rest of STNL sub 2 million you are generally looking at 5 to 6 caps. With debt for STNL low 5's it really doesn't work with debt hardly.

People often do not know how to properly evaluate these properties. Newly minted leases sub 2 million are generally 5 to 6 cap except for Dollar stores. Some people will send higher cap property flyers and say what about this? 8 cap with 5 years left on lease. Problem is if they are using debt lenders will want to use 10 to 15 amortization and make most cash flow go towards accelerating down the mortgage. So the higher cash flow buyer thought is happening is instead paying down principal. Lender wants dark value ( value of land and building without a tenant if tenant decides not to renew option) to be higher than remaining loan balance. This way if tenant goes out and owner cannot release and bank had to foreclose they could be made close to whole  on the loan.

Now there are smaller retail centers with 2 to 3 tenants under 2 million where a buyer could land a 7 plus cap rate and down payment of 25% and interest rate around high 4's with 25 year amortization and fixed for 7 to 10 years on the loan.

Even with interest rates rising most sub 2 million deals for STNL are cash so with buyers not using debt the cap rates will not adjust as much as say 5,6,7 million type properties where buyers with even millions down are getting debt to some degree to purchase.

Most of my commercial clients I like them to have 1 million down minimum when we look for retail properties. Net worth needs to be close to the loan balance. Example Aspen dental, T-mobile, Starbucks 3 top center for 3 million at a 6.5 to 6.7 cap rate with 30% down. 10% increases every 5 years and national corporate guaranteed in a high quality area.   

So 3 mill price,1 mill down, 2 mill loan, net worth 2 million, 10% liquid after down payment of loan so 200k. I do have a few clients we are closing on with 500k down but those have been really tough deals to do. Smaller strip centers with a few tenants.

If not a 1031 exchange but accredited investor then sometimes people will want to invest with me as a sponsor on some retail deals. Example buyer might be worth 1.5 million but only have 200k to do something with. Buying on their own nothing available in a good area where property and loan works with cap rate. Conversely they can invest the 200k in a 3 million property where I am the sponsor and own a smaller slice of a higher quality asset they could not currently buy on their own.

I typically hop on a call with an investor to discuss their individual goals, what there current net worth and liquidity is, how much passive versus active they want to be,etc. 

Originally posted by @Joel Owens :

Tons of variables at play. I review about a thousand properties a week for retail. Just like anything you have to buy right.

There are different types of commercial.

There is the mom and pop type retail condo's, street old town retail,etc. at cheaper price points maybe 1 million and under. Then when you go up in range you can start running into national credit tenants. Typically most properties under 2 million sell for cash STNL. There are some exceptions such as Dollar stores where you can buy at a 7 cap and have debt at a 5 rate for 200 basis point spread. Rest of STNL sub 2 million you are generally looking at 5 to 6 caps. With debt for STNL low 5's it really doesn't work with debt hardly.

People often do not know how to properly evaluate these properties. Newly minted leases sub 2 million are generally 5 to 6 cap except for Dollar stores. Some people will send higher cap property flyers and say what about this? 8 cap with 5 years left on lease. Problem is if they are using debt lenders will want to use 10 to 15 amortization and make most cash flow go towards accelerating down the mortgage. So the higher cash flow buyer thought is happening is instead paying down principal. Lender wants dark value ( value of land and building without a tenant if tenant decides not to renew option) to be higher than remaining loan balance. This way if tenant goes out and owner cannot release and bank had to foreclose they could be made close to whole  on the loan.

Now there are smaller retail centers with 2 to 3 tenants under 2 million where a buyer could land a 7 plus cap rate and down payment of 25% and interest rate around high 4's with 25 year amortization and fixed for 7 to 10 years on the loan.

Even with interest rates rising most sub 2 million deals for STNL are cash so with buyers not using debt the cap rates will not adjust as much as say 5,6,7 million type properties where buyers with even millions down are getting debt to some degree to purchase.

Most of my commercial clients I like them to have 1 million down minimum when we look for retail properties. Net worth needs to be close to the loan balance. Example Aspen dental, T-mobile, Starbucks 3 top center for 3 million at a 6.5 to 6.7 cap rate with 30% down. 10% increases every 5 years and national corporate guaranteed in a high quality area.   

So 3 mill price,1 mill down, 2 mill loan, net worth 2 million, 10% liquid after down payment of loan so 200k. I do have a few clients we are closing on with 500k down but those have been really tough deals to do. Smaller strip centers with a few tenants.

If not a 1031 exchange but accredited investor then sometimes people will want to invest with me as a sponsor on some retail deals. Example buyer might be worth 1.5 million but only have 200k to do something with. Buying on their own nothing available in a good area where property and loan works with cap rate. Conversely they can invest the 200k in a 3 million property where I am the sponsor and own a smaller slice of a higher quality asset they could not currently buy on their own.

I typically hop on a call with an investor to discuss their individual goals, what there current net worth and liquidity is, how much passive versus active they want to be,etc. 

Joel, I'm going to have to read your answer a few times to fully grok it.  I really appreciate your detailed response.  It gives me a lot to chew on.

@Tom J. I've noticed the same about BP in that its heavily weighted toward residential/mf/apartments. I've looked around but it feels like there's a need to be filled in the commercial space somewhere online similar to what BP does for residential.  I even created a Facebook group for the surrounding areas of Boston a month ago but haven't had time to add anyone else to it! 

What's your area of interest? And I checked out your site, good job!

@Tom J. ,  I invest in both commercial and residential real estate. In my opinion, neither is 100% superior over the other as they both have their pros and cons. I believe the best choice is to diversify into both.

Commercial can have fewer management hassles than residential, but it also can have much more. For example, if you invest in triple net leases with the tenant is responsible for everything (maintenance, taxes, insurance, etc.) it can be very easy to manage. On the other side of the spectrum is something like a hotel, which not only is a real estate business but also a convention/conference business and restaurant business. Those can be a lot to manage. So it's impossible to generalize.

As far as cash flow: again, it's not accurate to say that one always has more or less than the other. You can find plenty of residential deals that will project a higher or lower return than commercial, as it depends on the amount of leverage, the strategy, the place it's located in, the class of the property, etc.

Residential real estate:

1) Generally cheaper than commercial real estate, which allows smaller investors to purchase properties on their own and participate.

2) More cycle friendly. At least on a diversified, nationwide basis, residential real estate prices very rarely drop. In the last hundred years it's only happened twice: Great Depression and great recession. In contrast, commercial real estate prices are very cyclical and tend to drop every 18 years or so.

3) Much easier to sell, because not only are there other investors to purchase, but also people wanting to live in it. Commercial real estate can only be purchased by other investors which is a smaller pool.

4) Requires less specialized knowledge (as some has mentioned above) because most people understand residential real estate from owning a house. Commercial real estate and other hand can be very specialized and require specialized knowledge.

5) Can be a positive or negative: the price of residential real estate is based on many things that have nothing to do with the value of the property as an investment. This can mean that it's more expensive than it needs to be for investor, or it might mean that the investor can pick up a bargain. In contrast, commercial real estate is priced based on its income generating potential. There are some small modifiers, but it generally never gets out of whack from that value, like residential real estate does.

Commercial real estate:

1) generally generates more cash flow per square foot than residential

2) leases are much longer (other than apartments) and can last five to as long as 20 years. This can be a much more reliable income stream. Residential real estate leases are generally one year and so there is more tenant turnover and management expenses.

3) more variety: you can invest in everything from multifamily to retail to industrial to office to hotels to mobile home parks, etc. Each has their own unique risk profile, so it may be a better customized fit in your portfolio.

Originally posted by @Ian Ippolito :

@Tom J.,  I invest in both commercial and residential real estate. In my opinion, neither is 100% superior over the other as they both have their pros and cons. I believe the best choice is to diversify into both.

Commercial can have fewer management hassles than residential, but it also can have much more. For example, if you invest in triple net leases with the tenant is responsible for everything (maintenance, taxes, insurance, etc.) it can be very easy to manage. On the other side of the spectrum is something like a hotel, which not only is a real estate business but also a convention/conference business and restaurant business. Those can be a lot to manage. So it's impossible to generalize.

As far as cash flow: again, it's not accurate to say that one always has more or less than the other. You can find plenty of residential deals that will project a higher or lower return than commercial, as it depends on the amount of leverage, the strategy, the place it's located in, the class of the property, etc.

Residential real estate:

1) Generally cheaper than commercial real estate, which allows smaller investors to purchase properties on their own and participate.

2) More cycle friendly. At least on a diversified, nationwide basis, residential real estate prices very rarely drop. In the last hundred years it's only happened twice: Great Depression and great recession. In contrast, commercial real estate prices are very cyclical and tend to drop every 18 years or so.

3) Much easier to sell, because not only are there other investors to purchase, but also people wanting to live in it. Commercial real estate can only be purchased by other investors which is a smaller pool.

4) Requires less specialized knowledge (as some has mentioned above) because most people understand residential real estate from owning a house. Commercial real estate and other hand can be very specialized and require specialized knowledge.

5) Can be a positive or negative: the price of residential real estate is based on many things that have nothing to do with the value of the property as an investment. This can mean that it's more expensive than it needs to be for investor, or it might mean that the investor can pick up a bargain. In contrast, commercial real estate is priced based on its income generating potential. There are some small modifiers, but it generally never gets out of whack from that value, like residential real estate does.

Commercial real estate:

1) generally generates more cash flow per square foot than residential

2) leases are much longer (other than apartments) and can last five to as long as 20 years. This can be a much more reliable income stream. Residential real estate leases are generally one year and so there is more tenant turnover and management expenses.

3) more variety: you can invest in everything from multifamily to retail to industrial to office to hotels to mobile home parks, etc. Each has their own unique risk profile, so it may be a better customized fit in your portfolio.

 Ian, great perspective.  Thanks for taking the time to share from your experience and wisdom.  I appreciate it.

I don't have much to add here beyond saying that @Joel Owens is the forum expert in commercial so read his response a couple times. 

My logic is simple, people need a place to live so that is why I like residential. That being said, Joel and others do very well in commercial, so like anything, if you have knowledge you can succeed.