Should You Invest in Residential Real Estate or Commercial Real Estate?

Real estate investing can offer big rewards for those willing to take the financial risk on residential or commercial properties. Whether you choose to invest in one type of real estate or diversify your portfolio with both depends on your investment goals, your short-term or long-term strategy, and your level of risk tolerance.

Here, we'll look at the differences between the two types of real estate investing and the pros and cons of each to help you decide which is best for you.

A glass office building window with the sign Office Space for Lease.

Image source: Getty Images.

Commercial vs. residential real estate investing

Residential real estate covers a variety of housing types, including condos, co-ops, townhomes, mobile homes, single-family homes, and multifamily homes with four units or fewer.

The five major types of commercial real estate are retail, office, industrial, multifamily, and special purpose; the latter includes hotels, hospitals, and amusement parks, among other dedicated-use properties. Typically, a residence with five or more units is considered part of commercial real estate, not residential; student housing and apartment complexes are included in commercial real estate.

Though we'll focus on direct ownership and management of commercial properties in this article, real estate investment trusts (REITs) are another investment possibility. These are an excellent opportunity for real estate investors to add commercial investments to their portfolios without any direct landlord responsibilities.

So what are the advantages and disadvantages of the different types of investing? Here's a look.

Pros of commercial real estate investing

Triple net (NNN) leases

Commercial real estate often operates on triple net (NNN) leases. This means that in addition to tenants paying the rent, they'll also pay their share of the property taxes, insurance, and general operating expenses. As these costs run much higher than those incurred by residential real estate, it's good to know that your tenants are footing the bill.

Longer lease periods

While we're on the topic of leases, here's another major benefit: Commercial real estate leases typically run five to 10 years -- and sometimes even longer. The ability to determine cash flow for longer time periods is one of the major benefits of commercial real estate.

Additional streams of revenue

Savvy investors will find many more ways aside from rent to generate cash flow at their commercial properties. Coin-operated laundry in an apartment building and vending machines in an office lobby are just two of the many examples of passive income available for commercial real estate landlords.

Cons of commercial real estate investing

Larger financial investment

It costs much more to invest in commercial property than residential property, and it can be difficult for newer investors to secure loans without a hefty down payment -- usually between 20% and 35%. There are also higher costs in maintaining the property. While those are covered by your tenants' rental fees, you'll be on the hook for operating costs as well as your loan payments if you can't rent the space out.

Higher risk

Risk is inherent in either type of real estate investing, but it's even more so in commercial real estate. Aside from dealing with tenants, you may also have to worry about public access to your property. From theft and vandalism to on-site injuries sustained by employees or patrons, there are many more potentially risky issues that commercial investors must deal with than residential investors.

More responsibilities and work

Risks aside, the day-to-day management of a commercial property is more complex, and therefore more time-consuming, than managing a residential property. You'll probably have to hire a property management team to handle the responsibilities. You'll have peace of mind working with pros, but paying for them will cut into your profits.

Pros of residential investing

Higher demand

While the pandemic has shown us that people don't always need an office to work, people will always need places to live.

Easier to adjust rents

Residential real estate leases tend to be a year or even less, which means landlords have the ability to adjust rental rates as the economy dictates. Unlike with long-term commercial real estate leases, if the property value increases, residential investors will be able to raise rents sooner.

Less work and money to maintain

To be clear, maintaining a home is not without its responsibilities and expenses. But they are typically fewer and less intense than those in commercial real estate. A power outage in your single-family rental is still an issue but not as much of one as if an entire apartment building loses power.

Cons of residential investing

High vacancy rate and turnover

Shorter lease terms in residential real estate mean faster turnover and higher vacancy rates. An office investor can likely stay afloat despite vacant units, but if you're between residents for your single-family rental, you're operating at a 100% vacancy rate with no cash flow.

Strict rent laws

There are many laws in place that protect tenants to the detriment of landlords. In particular, during the pandemic, an eviction moratorium prevented landlords from kicking out tenants who fell behind on rent. While residential real estate investors should act responsibly in the interests of tenants, it can put them at risk of not being able to cover their own bills.

Limited ways to add value

Residential real estate investors simply don't have access to the numerous streams of income that commercial investors do. Yes, home improvements and upgrades can warrant higher rents and increase property value over time. But those upgrades would likely happen when the unit is unoccupied, which means there's no rent coming in while money is being spent.

Real estate investing has its risks and rewards

There are clear advantages and disadvantages to both types of real estate. Demand is high for housing, which is good for current investors, but low inventory makes it difficult for new investors to add properties to their portfolios. In the meantime, commercial real estate took a beating during the pandemic. The office and retail sectors are still struggling to recover, though industrial and multifamily are soaring.

As an investor, it is important for you to do your due diligence with all real estate opportunities so you understand the risks in owning and managing residential or commercial properties.

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