With inflation on the rise and the value of the dollar declining, many people today are considering adding real estate to their investment portfolios. Even though property prices have been steadily increasing over the past few years, investing in real estate can still be very affordable.
In this article we'll look at the differences between residential and commercial real estate investing and explain how much money you really need to invest in real estate.
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Residential Real Estate Investing
The first thing that comes to mind when people think of real estate investing is buying a residential rental property. That is perfectly understandable. Everyone knows what a house is and how one works, houses are found in the tiniest of towns to the largest urban areas of the country, and residential property is extremely easy to finance.
According to Zillow, the typical home value of homes in the U.S. is about $280,000. If you use a conventional loan with 5% as a down payment to finance your purchase, you will need just $14,000 to buy the home.
Investors looking for turnkey rental property already leased to a tenant can find houses for sale on Roofstock and Norada Real Estate Investments priced at less than $100,000. While most residential real estate investors hold property for the long-term, people willing to take on more risk with the hope of turning a quick profit can flip houses and wholesale homes.
But despite being a popular way to begin investing in real estate, residential rental property isn't always the right choice for every real estate investor.
Limitations of Investing in Residential Real Estate
Because homes are such a well-known commodity, there is a tremendous amount of competition from both individual and institutional investors. In addition, being a landlord is not nearly as easy as it might seem, even when you hire a local property management company, because you still have to manage your property manager.
- Houses are a lot of work: Most property management companies take 10% of your gross rental income as a monthly management fee. So, if a house rents for $1,500 per month, $150 goes directly to the property manager before any operating expenses are paid.
That is why many residential real estate investors opt for self-management, which creates a whole other set of potential problems.
When you are a landlord, you need to market vacant property and screen tenants, make sure the rent is paid on time, deal with handymen and contractors when routine repairs are needed. Plus, there are very specific state residential landlord-tenant laws to follow when and if a tenant needs to be evicted for non-payment of rent or destroying the property.
- You take all of the risk: Most people like the idea of owning real estate directly because they receive 100% of the reward. But what they do not think of is that they are also liable for 100% of the risk.
Responsibilities such as annual property tax payments, or funding capital expenditures such as replacing an entire roof or heating and cooling unit are entirely on you.
Direct property ownership also means you are a potential target for frivolous lawsuits, like when a tenant's guest injures himself on your property and decides to sue you for negligence.
- Feast or famine: While single-family homes are easy to find and finance, the cash flow that houses generate can be surprisingly inconsistent.
That is because when the tenant leaves, your vacancy rate is 100% until you can repair any damage caused by the previous tenant, then find a new tenant and sign a lease. In the meantime, you still have operating expenses and the mortgage to pay.
Because of ups and downs like these, some residential rental property investors find it can take years before the home actually generates consistent, positive cash flow.
Residential real estate can be very expensive
Residential rental property is often touted as the best way for real estate investors to earn passive income. If houses took care of themselves and tenants always paid their rent on time, that might be true.
But in the real world, many landlords find that renting a house is about as un-passive as it can be. As rising inflation pushes the cost of labor and materials to record highs, operating expenses can quickly spiral out of control. The result is negative cash flow, because you can't raise the rent until the current lease comes up for renewal.
In some states, it can take months to evict a tenant who does not pay the rent. In fact, a recent post on the BiggerPockets blog estimated that the cost of a residential eviction can be between $4,000 and $7,000, depending on the area the property is in and how long it takes to evict the tenant.
If your positive cash flow is normally a few hundred dollars per month, it can take two or three years before those expenses are recovered and you - hopefully - begin to turn a profit once again.
Commercial Real Estate
Investing in commercial real estate can be a good alternative to residential real estate, due to the higher income streams and the wider variety of investment opportunities. In fact, greater profitability and increased choices are two of the main reasons why residential rental property owners eventually begin investing in commercial real estate instead.
What is commercial real estate?
Unlike residential property which is rented to people to live in, commercial real estate is leased to businesses of all shapes and sizes. Sometimes companies purchase their own commercial real estate to occupy, and other times developers may invest in raw land to build office or retail projects, industrial property, or mixed-use projects. Lease terms in commercial real estate often run five years or more, include "built-in" rent increases, and can be specifically written to address the unique needs of the tenant and the landlord.
5 Types of Commercial Real Estate
Commercial real estate is generally categorized into one of five types, also known as asset classes. Each commercial real estate asset class also has sub-classes. For example, the main special purpose asset class can be divided into subclasses including senior living, student housing, data centers, and self-storage property.
Retail property ranges in size from a small storefront on Main Street to power centers and factory outlets. Space in a retail development is leased to tenants selling consumer goods and services.
Common retail tenants include grocery stores, clothing shops, beauty and barber shops, and insurance agencies. Many retail properties have a main tenant - referred to in the industry as an "anchor tenant" - such as a Whole Foods or Walmart, that draws customer traffic into the retail center.
Commercial office buildings include single-tenant properties such as doctor's office, mid- and high-rise office buildings in the central business district of a city, and large office campuses consisting of several low-rise office buildings across acres of land.
Office properties are often categorized by A, B, and C classes. For example, Class A refers to new office buildings with the latest amenities leased national and regional credit tenants, Class B is slightly older property, while Class C office space often has outdated floor plans, low ceiling heights, and is located in less desirable areas for business.
In the commercial real estate business, properties with four units or less (such as duplexes or triplexes) are classified as residential property, while buildings with more than four units are categorized as multifamily commercial real estate.
Multifamily housing types include garden apartments, low-rise multifamily buildings, and high-rise apartments that are often found in urban areas where land is scarce and expensive. Unlike other types of commercial real estate, multifamily property leases usually have terms of only 12 months, compared to multi-year terms in other commercial property types.
Industrial property types include warehouses and distribution centers, factories and manufacturing plants, refrigerated and cold storage centers, data centers, and flex buildings that offer a combination of office and industrial space.
One of the key differences between industrial commercial real estate and other types of commercial properties is the sheer size of the buildings. According to Warehouse Automation, Tesla is currently building the 4 million square foot Giga Texas industrial property in Austin, while the 4 million square foot Project Rodeo for Amazon is under construction in Denver.
The special purpose asset class of commercial real estate is sort of a catch-all category, but also one of the most potentially profitable types of commercial real estate to invest in. Property types included in the special purpose category include student housing and senior living projects, car washes and free-standing bank buildings, educational and religious buildings, and self-storage properties.
Owner-Occupied Commercial Real Estate
In the same way the homeowners live in the house that they buy, businesses can also owner-occupy commercial real estate. Generally speaking, a property is categorized as owner occupied commercial real estate (OOCRE) when the owner occupies 51% or more of the total space. Sometimes a business will purchase a property for its own use, sell the property to an investor, and then lease the building back. By conducting a "sale-leaseback", businesses can convert equity into cash, while investors benefit by having a higher and more predictable rate of return.
Commercial Real Estate Investing Benefits
Lease terms in commercial real estate usually run for several years. This means that cash flow is more predictable because tenants do not turn over every year as they do with residential rental property. Commercial real estate leases can also be written so that the base rent increases by the CPI change each year, and to allow landlords to pass through some or all of the building's operating expenses, which reduces the risk of ownership to the investor.
Because most types of commercial real estate are occupied by multiple tenants, investors benefit by having multiple income streams flowing from the same property. For example, when a tenant in a single-family home leaves, the vacancy rate is 100%. On the other hand, if five tenants in a 100-unit self-storage facility happen to leave at the same time, the occupancy rate is still 95%. Because tenant turnover is lower, incomes from commercial property are generally higher, which is why commercial real estate can generate a greater ROI compared to residential rental real estate.
Commercial property is normally leased to businesses for 5, 10, 15, and even 20 years or more at a time. In order to ensure that gross rental incomes are maximized, a commercial landlord can adjust the annual rent using a CPI increase to match the change in inflation. Most long-term leases in commercial real estate are also net leases, which means that operating expenses such as property taxes, building insurance, and maintenance are passed through directly to the tenant.
Many investors have the misconception that commercial real estate is difficult to invest in. To be sure, financing and managing commercial property is more complex, which is why many investors participate in a private equity commercial investment offering rather than trying to directly own a commercial property. Of course, less competition for commercial real estate also means more potential opportunity to earn passive income compared to residential investments.
Limited operating hours
The majority of commercial buildings are occupied by tenants who work normal business hours. This makes managing a commercial property much easier, because a landlord doesn't have to be on call 24 hours a day, 7 days a week to make an emergency repair or deal with tenant communication at all hours of the day and night.
Better business relationships
Because commercial real estate tenants are more professional, it's much easier for landlords and tenants to build a better business relationship with one another. When a tenant's business is successful because the property is managed well, the tenant oftentimes is able to expand and lease more space. In commercial real estate, there's a built-in incentive for both parties to treat each other professionally and create a win-win situation.
How Much Money Do You Need to Invest in Commercial Real Estate?
The money needed to invest in commercial real estate is much less than most people think. In fact, compared to buying a house in many parts of the U.S., commercial real estate investing can be very affordable. Rather than attempting to purchase and operate a property directly, you can allocate smaller amounts of capital to a variety of commercial real estate investment opportunities. By doing this, it is much easier to diversify your investment portfolio and generate higher potential returns. For example, while it may cost many millions of dollars to purchase a self-storage facility outright, investing in the Reliant Real Estate Fund II requires a minimum of only $50,000.
The money you need to invest in commercial real estate is much less than most people think. By partnering with an experienced investor, you can easily add commercial property to your investment portfolio and benefit from the robust cash flows, tax benefits, higher returns, and hedge against inflation that commercial real estate investments provide.