Residential vs Commercial: Which The Better Real Estate Investment

A lot of investors are getting a chunk of their fortune in real estate investing like author Robert Kiyosaki writes about. However, there is a diverse opinion on what property type is best to invest in.

If you’re more into numbers and straightforward business, some investors may suggest that you take the commercial property path. On the other hand, if you love the idea of a “units based” business then residential property investing might give you a more fulfilling feeling.

In order to do your homework with due diligence, here’s a more detailed approach for deciding on your first property investment.

Real Estate Funding Options

Most residential investors deal in hard money or cash but when it comes to commercial the numbers are so high you need other options.   We’ll look at hard money below, but as they say, “Cash Is King.”

Commercial real estate has a higher value than residential properties. However, this doesn’t limit the funding options available for commercial properties. Loans include but are not limited to the following:

  • Traditional Bank Loan –  Banks usually applies 4%-6% interest rates to commercial loans. But the loan terms are ranging from 5- 10 years. In spite of the higher cost, banks are more than willing to release funds to a high performing commercial property than residential.
  • SBA 7(a) Loan and 504 Loans – Small Business Administration(SBA) loans are intended for small operating businesses but can be also be repurposed to purchase a commercial property. You can loan up to $5 million dollars payable up to 25 years.
  • Mezzanine Loan – One of the high-risk form of debt but offers one of the highest forms of returns. Simply put, it fills in the needed amount to complete the purchase. Usually, the transaction is between the senior lender and the equity shouldered by the sponsor.
  • Hard Money – Loans comes from private companies and investors which works by receiving funds in securing a property. It is one of the go-to paths of properties with distressed financial situations.
  • Crowdfunding – If you got declined in traditional banks, Equity crowdfunding is a viable option and allows multiple investors to pitch in and raise the amount demanded by the purchase. Consequently, profits will then be shared among all investors. You may check on Patch of Land or Fundraise to get started.

Due to high capital that goes along with commercial properties, applications are prone to more in-depth analysis and approval process. So make sure to hire a professional chartered surveyor, prepare 3 – 5 years worth of financial statements, accounting reports, taxes, and other financial records. It takes up to 3 months to finish an application.

If you buying a home as an investment and want to use more traditional financing there are many options to choose from:

  • Conventional Mortgage –  Conventional Mortgage is offered by private institutions, credit unions, banks, and private lenders and not secured by the government. This type of funding requires a down payment by 20% but for investment purposes, it requires up to 30%. For 2019, a conventional loan must not exceed $484,350 to be covered by Fannie Mae and Freddie Mac

What is Fannie Mae and Freddie Mac?

Federal National Mortgage Association is commonly known as Fannie Mae. And, Federal Home Loan Mortgage Corporation is known as Freddie Mac. These two companies are government-sponsored enterprises that allow lenders to reinvest their assets into more lending opportunities. Freddie Mac and Fannie Mae create a secondary mortgage market for lenders that are insured by the federal government.

  • FHA 203k Loans – This loan allows people to either purchase a home or serve as financial aid for home improvement. Federal Housing Administration guarantees this loan which makes it easier to get approval and offers more affordable mortgages.
  • Hard Money – Hard money or private money is short term loans that are usually paid from 12 months up to 6 years. This kind of loans is a bit risky as there is no guarantee by the government.

Keep in mind any of the above options will cause you to be competing with other buyers.  A prospective seller won’t see your financed offer as “better” simply because you’re an investor.  Often the advantage investors have is that cash is perceived as better and less of a hassle.   A good example is FHA 203k loans while these loans are great if you can complete them, they often involve many moving parts creating more hassle.  Most sellers prefer less hassle than even more money.  In that instance, you could buy the home cash then do a refinance or a heloc.

  • Home Equity Loans and Lines of Credit(HELOC) – This loan scheme in simpler terms is the act of taking your home as collateral to take out a loan for another investment.  Note that you have to actually OWN the home first.

Maintenance

Residential homes may tend to require more maintenance shouldered by the owners or even the tenants. A small residential wouldn’t need a property manager due to its smaller capacity. Moreover, there are available ways on how to manage residential maintenance cost in aid to every owner’s dilemma.

As for the commercial ones, the advantage comes from the available lease terms with commercial properties. These include:

  • Net Lease – This commercial estate lease usually allows tenants to handle one incidental expense like property tax aside from the base rent.
  • Double Net Lease – A commercial estate lease where you pay the base rent + 2 incidental expenses(property tax, insurance, utilities, maintenance, and repairs).
  • Triple Net Lease – The most ideal of all commercial estate leases is the triple net lease. In this agreement, all the incidental expenses are shouldered by the tenant.

On a broader perspective, commercial properties may come as complex in terms of legalities and contracts but the above lease terms significantly reduce costs to the owner. Consequently, commercial properties may need property management to maintain the place if the agreement is not on Triple net lease. Businesses such as Walmart are usually on triple net lease. This is to have control of how they wanted to present their company to their market.

As for residential properties, maintenance is usually taken care of by the owner. He/she may just need the help of some utility professionals to keep the property in a good condition. As a consequence there residential property investing can place more stress on the investor/owner of the property.

However, in commercial properties, larger companies often have the luxury of using a property management/maintenance company.

In both two types of investing both properties require maintenance, however, larger organizations often have economies of scale working in their favor which leads to cheaper on-going property maintenance.

Real Estate Tax and Allowances

Residential property tax depends on the value of the home. Usually, tax ranges from 0-4% of the property’s value. While for commercial properties, tax is calculated based on its income and business category.

A foreign individual owning commercial property can be taxed at 39% of his net income, On the other hand, the U.S and Foreign corporations are taxed at 35%.

Opportunities and Potential ROI

The potential ROI for commercial properties ranges between 6% -12% while 1% – 4% for residential properties.

Commercial properties are driven by the movements in the economy. Though risks are higher, many investors still take it because of the growth in income potential. After all, investment is a big gamble.

Residential properties are driven by demand. So, with the right strategic location and other factors, your residential property can secure you a steady profit. But compared to the longer lease offered in commercial properties, security and growth can both be probably achieved.

Value appreciation

Real estates’ value appreciates over time but not at the same rate and factors. One of these factors is, In figuring out the value of a residential property, the average value of the real estates sold in the area is one of the basis.

Commercial property value is determined by its income and cash flow. So some investors take advantage of this by pushing for bigger income and force the property’s appreciation.

Period of Uncertainty

Real estate owners’ nightmare is when there’s no tenant. Time is money so the longer the property is vacant the more opportunities are lost. At this rate, lease terms play a great role in comparing commercial and residential properties.

Residential properties lease terms normally last for a year. Unless the tenant renews their contract, there’s no guarantee for the next tenant. While in commercial properties, lease terms can last for at least 5 years.

Comparing 5 years of income over a year’s earnings can definitely give you a better look on which is favorable. But, you must also take into consideration that businesses are also prone to unforeseen situations such as bankruptcy.

Peace of Mind

The world can give you all the reasons to pick an investment. But it’s really depending on you as an investor. Your investment should be inclined with your personality and principles in life.

Someone who loves numbers and black and white transactions may find it hard to stay in residential property investing. This is due to the fact that residential property investing is an emotional endeavor. The buyer or tenant’s feeling about the place are taken into consideration.

The same goes with an ‘emotional’ investor. He may never find the oy of his investment within the stricter rules in commercial property investing. Not to mention the 30 to 90 days leasing preparations between the owner and the business. In commercial property investing, a business that can add more value to the property will always seal the deal.

It is advised to set your personal investment criteria and not just go with what others tell you.

In a nutshell, if you’re just starting in real estate investing, it’s best to start with residential property for security.

Once, you’ve established the necessary knowledge then you may start with the bigger gamble in commercial property investing for growth.

We hope this article helped you clear out the questions you have in real estate investing. If you recently started investing, we’d love to know your experiences in the comments down below.

 

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