Should I invest in residential or commercial real estate? (Part 2: Commercial)
Understanding commercial real estate, and choosing between the two.
January 15, 2016 BY IAN IPPOLITO
Many so-called “experts” will tell you that residential (or commercial) investing is significantly better than the other. However, most are only familiar with the one that they recommend. Before making your first investment, it’s vital to fully understand both, so you can figure out what makes the most sense for you.
In part one of this tutorial, we talked about residential investing. In this part, we’ll talk about commercial investing.
What is it?
Commercial real estate involves structures that businesses occupy (and/or the land under them). This includes office, retail, industrial, apartments (5+ rental units), hotels, self storage, mobile home parks, etc.
Commercial investing usually generates more cash flow per square foot than residential. This means it tends to be much more profitable. This is a huge difference and no doubt one of the main reasons that many people invest in commercial real estate.
Also, the leases on commercial investments (other than apartments) are generally much longer (often 5 to 20 years versus one year). So it usually produces a much more stable and reliable income stream.
However, commercial real estate is not without its downsides.
Every rose has its thorn
Commercial investing has historically required much deeper pockets than residential. A typical investment might require millions of dollars instead of a few hundred thousand. Larger commercial projects are in the hundreds of millions of dollars.
Banks financing loans usually require 30% or more down, which also makes funding more difficult.
For these reasons, traditionally only the wealthiest investors could afford to invest in commercial. However that’s now changing. With the invention of real estate crowdfunding, the entry cost has dropped as low as $2500, and is now in reach of practically every accredited investor. (See What Is Real Estate Crowdfunding?)
Eventually, crowdfunding will be accessible to all investors, and minimums will drop even lower. So this issue is becoming less and less of a problem.
However, the other major downside of commercial real estate will probably never go away. Commercial real estate is much more volatile and cyclical than residential.
Before the Great Recession, residential real estate had never experienced a nationwide downturn for almost 100 years (the last time was the Great Depression). In contrast, commercial tends to go through a down cycle about every eight years. That’s more than 10 times as volatile.
So it’s really important to time commercial investments properly.
Also, each individual asset type has its own unique cycle, which can be significantly different than the others.
For example, right now, apartments are mature in their cycle while industrial properties are very early in their cycle. And on top of that, each individual geographical market may be a bit ahead or behind on the national cycle.
So it’s important to keep track of all of these things and consider them in any potential commercial real estate investment. (See What Is the Real Estate Cycle?) This requires a lot more homework than the typical residential real estate investment.
In a recession, the different asset types are not created equal. Some have alot more be recession risk than others.
For example in past cycles hotels (lodging) have been the most volatile (first to get hit, fell the farthest and stayed down the longest). And on the other side of the spectrum are mobile home parks and multifamily which historically have been much steadier.
However there is one big caveat to the above. Too much new construction in the area of a property you buy can easily spoil the party and make a historically safe asset class very risky.
Many would say that's happening right now in many markets in self storage and senior housing (and in many primary markets and downtown areas with multi family). So you have to understand the risk of that unknown. And a smart investor does their homework at the property level to minimize a chance of a nasty surprise.
Mobile home parks (manufactured homes) have a unique advantage here of being so unpopular in communities that barely any new ones are being approved. So this keeps supply down. On the other hand it's very hard to find quality deals because everyone knows this, and the industry is also very fragmented.
Due to the above issues, timing is crucial. It’s important to fully understand the asset class and stay up-to-date on the latest trends.
For example, in the retail world, power centers were heavily in favor for a long time. However, with the rise of the Internet and e-commerce, these are no longer the safe bets that they once were.
There are many companies that offer this crucial analytical information for free on the Internet such as Marcus and Millichap, and the Urban Land Institute.
Equity or debt?
As an investor, you can choose to invest in commercial real estate via either equity or debt. (See What’s the Difference between Equity and Debt?)
Income is often done through a lease that can be either single net, double net or triple net. Single net require you to be responsible for much of the maintenance. Triple net puts all of the maintenance responsibility on the tenant. This creates a very low maintenance investment and when done on high quality credit tenants, can be similar in safety to a bond.
Final conclusion: Which is better?
There are many people that will tell you residential investing is much better than commercial (and vice versa). So which of the two (residential or commercial real estate) is objectively the best? There’s no single answer to this that applies to everyone and at all times. The answer depends on your investment goals, tolerance for risk, and where we happen to be in the cycle.
Residential real estate is less risky and requires less homework and knowledge. But it also has lower returns. Commercial real estate returns much higher yields, but it’s also much more volatile and requires much more understanding to choose wisely.
In my opinion, choosing between the two is a false choice, and a remnant of an older time. Before crowdfunding, it made sense that many investors would choose to concentrate on only one of the other, so they could build up all the necessary knowledge. But today, it’s possible to invest in both, and I believe a properly diversified portfolio requires both.
Commercial real estate yields more but is more volatile. So I favor it in my portfolio when the commercial real estate cycle is favorable. However, as it starts to age and gets near the end of the cycle, I move my assets into residential real estate. If both look overheated, then I move assets into cash or alternative investments.
What's your opinion?
About Ian Ippolito
Ian Ippolito is an investor and serial entrepreneur. He has been interviewed by the Wall Street Journal, Business Week, Forbes, TIME, Fast Company, TechCrunch, CBS News, FOX News and more.
Ian was impressed by the potential of real estate crowdfunding, but frustrated by the lack of quality site reviews and investment analysis. He created The Real Estate Crowdfunding Review to fill that gap.