Most real estate investors talk about the two main types of real estate: residential and commercial.
What are they? What are the differences between them? What are the pros and cons of investing in each? How do I know which one to pursue? We’ll cover the answers to those questions and more in this article.
(We will not be covering traditional commercial properties such as leasing offices, retail spaces, double net (NN), or triple net (NNN) commercial leases.
What is Residential Real Estate?
According to Investopedia.com, residential real estate (RRE) includes undeveloped land, houses, condominiums, and townhouses. The structures may be single-family or multi-family dwellings and may be either owner-occupied or rental properties.
What is Commercial Real Estate?
Commercial real estate (CRE) includes nonresidential structures such as office buildings, warehouses, and retail buildings. These buildings may be free-standing or in shopping centers.
However, for the sake of this post, and most residential real estate discussions, if someone is referencing CRE within the context of residential property, they are most likely referring to a property with five or more units.
One of the major differences between RRE and CRE, from a lender’s perspective, is the number of units.
- RRE is comprised of 4 units or less
- CRE is comprised of 5 units or more
Thus, many investors have adopted their lingo from lenders and will reference both RRE and CRE when referring to residential property.
How Does Financing Differ for Residential vs Commercial Properties?
The financing for residential properties and commercial properties differs significantly.
For most RRE investments, the lender will look only at the buyer’s financials and determine if they can lend to the buyer on that specific property. If the property has between 2-4 units, the lender may consider the rent from those units as part of the buyer’s income, making the borrower a stronger buyer, but this is lender-dependent.
For CRE properties, the lender will always take into account the income from the property. The buyer’s financials are still taken into consideration, but often times if a well-performing property is to be purchased, the borrower’s financials don’t have to be as strong. That is why it is typically easier to get a commercial loan even if the borrower does not have a W2.
For each type of loan, there are different loan structures, products and terms for each class.
A typical loan for an RRE property can be amortized over 30 years and will have a fixed payment for the entire 30-year period.
A typical loan for CRE can be amortized over 20-25 years and may have a fixed rate for 5 or 10 years. After the initial fixed period, the interest rate can adjust to the market rate at the time.
When compared side by side, the CRE loan will likely have a higher interest rate.
The Pros and Cons of Each Investment
When considering what type of loan to utilize, there are several factors to consider. Here are some of the pros of each investment type:
Pros of Residential Real Estate
- Will typically qualify for the cheapest lending products
- Long-term debt available which makes the loan very safe if you calculate your numbers correctly.
- History has shown that rents over a long enough time horizon increase, while your mortgage payment remains the same for the life of the loan.
- Financing is a fairly straightforward process.
- You can fund up to four units with a traditional lender’s residential products.
Cons of Residential Real Estate
- Scalability - you need to do numerous deals to get to the desired unit count or income.
- Many lenders will not take into account the property’s income when underwriting the loan (i.e. you need to qualify on your own income to purchase the property).
- If purchasing a single-family home, your vacancies are a 100% loss in rental income. This starts to decrease with an increase in unit count (duplex, triplex, quadplex).
- Most lenders will not lend to an LLC with an RRE product.
Pros of Commercial Real Estate
- You can scale unit count very quickly by purchasing larger buildings.
- Scalability allows for discounts on numerous aspects of building ownership.
- For example, you can save on maintenance costs with a handyman going to a single property to fix five things, rather than having to go to five properties to fix one thing at each property.
- Property management typically becomes cheaper with more units under management.
- Allows for less rental loss with each vacancy since in a five-unit building, one vacant unit is only a 20% loss of the total rental income potential. This obviously decreases with an increase in unit count.
- On a per-door basis, CRE is typically less expensive than RRE because you’re buying in bulk.
- You can qualify for lending with an LLC.
Cons of Commercial Real Estate
- It’s typically more expensive to finance CRE than RRE.
- Usually shorter fixed mortgage term
- Some may view it as putting more eggs in one basket
- If you make a mistake with a CRE purchase, the effect will likely be compounded due to the higher unit count.
- For example, if you purchased a building that needed all new plumbing, that will be significantly more expensive on a bigger building than on a smaller one.
How Is Each Type of Property Valued?
RRE is typically valued using the comparable sales approach (aka using comps). If a property in the neighborhood sold for around $100k, it’s safe to assume that like-kind properties (of similar size and finish) will also sell for around $100k.
Many buyers approach RRE more emotionally since many buyers may be owner occupants and not investors. For example, if a potential buyer walks into a property and absolutely loves the kitchen or is very impressed with the backyard, they may be willing to pay more for the property. Conversely, if they dislike features about the property, they will likely be willing to pay less than asking, or not even offer at all.
CRE is valued very differently according to capitalization rates and net operating income (NOI). The equation is: property value = NOI/cap rate. Remember, NOI does not take into account mortgage payments.
So if you own or are looking to purchase a property that generates $10,000 annual in NOI and the area is trading at a 5% cap, the asking price would likely be $10,000/0.05 = $200,000.
Cap rates are mainly driven by the market that the property is in. However, if you have a dilapidated property in a great location, you can purchase it at a high cap rate, improve the building and sell it at a much lower cap rate. This method is part of the BRRRR strategy, which I’ve written about here.
Remember: the lower the cap rate, the more expensive the property.
How Do I Know Which Property Type to Invest In?
The first step in answering this question is to determine your “why.” That is, what is driving you to invest in real estate in the first place?
Once you’ve determined your “why,” you can start to look at the various options within real estate investing.
Ask yourself this...
What is my ultimate goal with real estate?
- Replace job income?
- Obtain a certain monthly cash flow and retire?
- Spend more time with family?
- Help take care of the family?
- Give back to the community/cause?
- Start a non-profit?
If your goals involve the generation of large amounts of cash and your time horizon is short, then commercial real estate is likely the way to go.
If your goals require less cash generation, then RRE may be the way to go.
On a per-building basis, CRE typically generates more cash flow than RRE, but also typically requires more capital and time. CRE is typically more time-intensive to manage simply because there are more units involved.
Some additional factors and questions to consider are:
- How many transactions would you like to do?
- How are you planning on managing the property?
Wrapping Things Up
You should familiarize yourself with the differences and similarities that each type of real estate investment has to offer and see what resonates with you. Some people only buy RRE and swear by it. Others exclusively purchase CRE.
There is no right or wrong in real estate - it is only a matter of what works and doesn’t work for you. Find your niche, become great at it, and enjoy the ride.