Residential and Commercial Real Estate Investing

As a real estate investor, one of the first big decisions you will need to make is whether to invest in residential or commercial real estate. Since different property types come with their own financial and maintenance implications, be sure you analyze all the aspects of a deal, beyond just running the numbers.

Residential or commercial? Investing in real estate is one way to build wealth, but choosing between these two common types of properties can be daunting for new investors. Both residential and commercial real estate have their pros, cons, and potential risks and rewards. Ultimately, the decision to go with one or the other will come down to your investment goals, market factors, and financing.

What’s the difference between commercial and residential real estate? 

Commercial real estate is generally used for business-related purposes and can include office buildings, hotels, restaurants, warehouses, factories, retail spaces, healthcare facilities, and multifamily housing that has five or more units. For investors whose priorities are cash flow, property appreciation, and long-term business growth, commercial property investment could be the right choice.  

Commercial tenants are typically businesses that are using the space for professional purposes. Leases for commercial spaces are typically longer than those for residential spaces, ranging from three to 10 years or longer. This is intended to provide stability for the business, as well as give them confidence that they’ll be able to effectively utilize any improvements or upgrades they may make.  

Residential Real Estate

Residential real estate is property used for living space, including single-family homes, condominiums, townhomes, and multifamily housing with four or fewer units. Investment strategies usually focus on long-term property appreciation and generating steady income streams. 

Tenants are generally individuals, roommates, or families, and residential leases tend to be shorter than commercial leases, usually ranging from a few months up to around two years, with options to renew at the lease’s end. 

Learn more: What Type of Rental Property Suits You?

Should you invest in commercial or residential real estate? 

Your investment goals, risk tolerance, experience, and finances are the primary factors to weigh when deciding between commercial or residential real estate. Consider the following pros and cons of commercial versus residential real estate. 

Understand the Potential Risk and Reward 

People always need places to live, and because housing demand is relatively constant, residential real estate can be less affected when the economy takes a dip. From an investment standpoint, residential properties can provide more stable and consistent income, though they might not offer the same potential for high returns as commercial ones.  Still, it’s vital to keep in mind that not all residential properties are the same; those in areas with high vacancy rates or located in overvalued housing markets will be a riskier investment. As for liquidity, reselling residential properties tends to be a faster, more straightforward process than reselling commercial real estate due to the higher number of buyers. 

Strategically located commercial properties are typically able to command higher rents from businesses seeking premium space. Some commercial landlords use “triple net” leases, in which the tenant covers expenses like property taxes, insurance, and building maintenance. This dramatically simplifies things for owners, who typically accept less profit than they would otherwise in exchange for a more hands-off, less risky income stream. 

While commercial real estate has the potential to yield high returns, it’s often viewed as a riskier investment. Businesses are subject to economic ups and downs, and can go under if the economy tanks, resulting in commercial properties without tenants. It can take much longer to fill a vacancy or sell a commercial property than a residential one due to the specialized nature of both the property and the tenant, as well as zoning and other factors. 

Assess Tax Benefits and Implications

The tax benefits associated with both commercial and residential properties are similar. Both types of investment properties, for example, can deduct mortgage interest, thereby reducing an investor’s taxable income.  

Both commercial and residential investors can deduct operating expenses, which can include repairs and maintenance, property management fees, utilities, insurance, and advertising and marketing costs. 

In addition, both residential and commercial investments can take tax deductions for property depreciation, but the depreciation schedules are different in length.  In the US, commercial properties depreciate over a 39-year schedule, compared to 27.5 years for residential properties. 

On the whole, owners of residential properties usually pay lower property taxes than commercial property owners. However, some municipalities offer tax incentives to commercial investors as a means to stimulate economic development and new business, or revitalize specific neighborhoods or districts. Such tax incentives could include things like reduced tax rates, appraisal freezes, or tax credits.

Commercial properties sold at a profit will incur capital gains tax. Residential properties will also incur capital gains taxes when sold for profit, but some limitations may apply. Up to $250,000, or $500,000 for married couples, can be exempted if the home was used as a primary residence for at least two of the previous five years. 

Both types of properties are eligible to utilize the 1031 exchange provision. With a 1031 exchange, investors who sell a commercial or residential property and reinvest the proceeds in another “like-kind” investment of equal or greater value within a specified time frame may be able to defer capital gains taxes. 

The tax implications for buying, holding, and selling either type of property is one of the more complex aspects of real estate investing. Consult with a trusted tax professional for a clear understanding of your potential options and obligations before making a decision. 

Evaluate Financing 

Traditional mortgage loans and down-payment requirements are usually available for most residential properties, which opens the door to more individual investors interested in residential property.  

Investing in commercial real estate requires a significant amount of upfront capital, which might limit many investors from entering the market. Financing commercial properties can also be more complex, involving commercial or jumbo loans or real estate partnerships among groups of investors, as well as shorter-term loans that need to be refinanced.

Define Your Management Style

For investors who prefer hands-on management, residential properties involve dealing with individual tenants, property maintenance, tenant turnover, and marketing. Novice real estate investors may appreciate the simpler leases and less-complicated management requirements of residential properties if they prefer to self-manage–though hiring a property manager can also be an option for residential properties.

Managing commercial properties involves maintaining professional relationships with multiple commercial tenants and municipalities, negotiating complex lease agreements, and large-scale property maintenance. Commercial property management is often handled by a professional team with specialized knowledge and experience, which may be ideal for investors who want a more passive investment and are willing to leave the day-to-day details to experts.

Seek Professional Advice

Investing in real estate of any kind involves myriad details, legal considerations, and tax implications. Get advice from real estate professionals, financial advisors, and legal experts for advice tailored to your circumstances and investment goals. Remember that even an excellent deal on paper may not be a great deal for your business needs and investment goals. If you are a new real estate investor, or you are starting to invest in a new type of real estate, finding mentors and expert advice can be the key to making the best financial and lifestyle choices for your long-term needs.