RESIDENTIAL VS COMMERCIAL REAL ESTATE INVESTMENTS: WHICH IS RIGHT FOR YOU?
COMMERCIAL REAL ESTATE
Commercial real estate investments are properties that are used for business-related purposes as a workspace.
Examples of commercial real estate: Shopping centers, office buildings, hotels, gas stations, restaurants, strip malls.
Typically, businesses don’t own the buildings or properties they occupy. Instead, they lease the space and focus their effort and capital on the core business where they expect to make better returns. This provides opportunity for landlords and investors to own investment property and collect rent from businesses as tenants.
Lease terms can be anywhere between one and ten years. Larger tenants (i.e. retailers such as Target or Walmart) usually have leases that are longer than average. Office and retail tenants usually have leases between five and ten years.
Overall, shorter leases provide opportunity to adjust rent rates more frequently. Long-term leases allow for more security and stability in rates as well as tenant turnover.
Investopedia lists the four types of commercial lease agreements commonly found between landlord and tenant:
- Single Net Lease: Tenant is responsible for paying property taxes
- Double-Net Lease: Tenant is responsible for paying property taxes and insurance
- Triple-Net Lease: Tenant is responsible for paying property taxes, insurance and maintenance
- Gross Lease: Tenant only pays rent. Landlord is responsible for paying property taxes, insurance, and maintenance
Commercial Real Estate Investing
Commercial real estate offers investors a strong way to diversify their investment portfolios and hedge against stocks and bonds.
Investors make returns in two different ways:
- Property Appreciation: Investors make money when they sell the property if it appreciated in value over the holding period. Real estate is known to increase in value over time, so investors can estimate annual returns from appreciation of the property.
- Rental Income: Most returns for investors come through rental income collected from tenants. This is often calculated as annual rental income per square foot.
With commercial real estate, it’s important to understand the fundamental characteristics and how they affect your investment decisions.
- Attractive Lease Rates: Commercial real estate provides investors with higher rental rates per square foot. It can give investors higher returns and a healthy monthly cash flow. Look for areas that are constricted by empty space or limited by construction laws. Limited supply will result in higher lease rates.
- Longer Lease Agreements: As mentioned above, lease agreements are usually multi-year contracts. They can provide cash flow stability for landlords and investors. Less tenant turnover means less time for vacancy.
- Longer Investment Period: Commercial real estate investments are usually longer-term investments. They can be as short as a couple years, but often stretch into decades if the property produces enough cash flow for investors.
- Rules and Regulations: Commercial real estate is known for intricate and detailed rules and regulations. This creates a higher barrier-to-entry for many markets. Taxes and other legalities can vary by state, or even local, becoming a deterrent for some investors.
RESIDENTIAL REAL ESTATE
Residential real estate is property that is used as living space. Tenants are using the property as their place of residence.
Examples of residential real estate: Houses, multi-unit homes, townhouses, and duplexes.
Some of the same principles apply to residential real estate. Investors own residential property and tenants pay rent to live there.
Leases are much shorter with residential real estate. One-year lease terms are common for most residential properties, while month-to-month options are also quite common.
Residential Real Estate Investing
Residential real estate offers two primary investment strategies, focusing on a short vs. long-term approach.
- Buy-and-Hold: This represents the longer-term approach of buying a property and holding over multiple years. Investors will lease the property to tenants to subsidize the monthly property costs. In this strategy, investors are betting on the long-term appreciation of the property’s value.
- Flipping: This is the strategy of finding a distressed or undervalued property, making improvements, and selling the property in a short time frame. Investors are looking to add value to the property and ‘flip’ it back onto the market for more than the purchase price.
- Shorter Lease Agreements: People tend to live in their houses for shorter periods than a business occupies a building. This gives investors more flexibility to increase rates along with the market over time, but brings more risk of tenant turnover and vacancy.
- Shorter Investment Period: For investors, residential real estate is used for shorter-term investments. This is especially true of the flipping strategy where investors are typically looking to sell the property within one year of purchase.
WHICH IS RIGHT FOR ME?
There are two main factors to consider when deciding between commercial and residential real estate: Timing and ROI.
Commercial deals often require more time than residential leases. Commercial deals can easily be two year projects or longer. Residential deals can be completed within six months.
Commercial real estate is a better long term investment for those looking to see compounding returns over several years. With San Diego real estate values appreciating at high rates, commercial investors are currently opting for a buy and hold strategy.
Residential real estate can offer a quick return for those looking to see their ROI in a quick time frame. Residential properties in San Diego are getting bought and remodeled in order to sell for a fast return.
San Diego is in the midst of a rapid urbanization movement. The downtown area is an active real estate market sought after by both commercial and residential real estate investments. Opportunities in both areas are trending upward as investors realize the growth potential of urban San Diego.
FortuneBuilders provides the following commentary on the real estate market in San Diego:
“The San Diego housing market has a healthy demand, meaning investors will find conditions encouraging. As it stands, Zillow has already projected a 1.7% increase in housing prices over the next 12 months. Everything points to San Diego having an extremely healthy market that favors neither buyers nor sellers. Despite rapid appreciation, San Diego is heading in the right direction. The good news for buyers: Interest rates remain low and prices appear to be stabilizing.”
Whether you decide the commercial or residential route is best for your real estate investments, you should end up with a good result from the healthy markets in San Diego.