Ben Mizes, Clever’s CEO, posted a thorough comparison of real estate versus stocks late last year, pitting real estate investment against the market in a head-to-head. The outcome showed the benefit of a mixed approach and the advantages of both.
It got me thinking about other investment comparisons and about one within property investing itself.
What about residential versus commercial property? Which is the best mix of returns and other benefits for your investing dollar?
You see so much on the internet about residential rentals that it can be easy to forget commercial investment is even an option. I think that’s an opportunity for the investors that look at both property types, understand the pros and cons of each, and can use each to get the best of both worlds.
Let’s look at the two types of property investment, the pros and cons of each and how to make the most of them. I’ll show you why I have most of my real estate portfolio in residential but why I still love commercial property for a stress-free part of the plan.
Investing in Residential Rentals
Residential rentals are pretty much all you hear about when it comes to property investing. From the 3am infomercials from some ‘real estate king’ to the countless YouTube channels for flippers, landlords and would-be property moguls…everyone loves the rental game.
But it’s not all rainbows and unicorns. I jumped into residential rentals head-first after getting out of the military in 2001. I was the poster-child for the pyramid rental scheme. I bought a fixer-upper on the cheap with money I saved in the Marines, fixed it up and refinanced the higher value to buy another house within six months.
Within two years, I had six single-family rental units. Not bad except I was also working a full-time job and studying nights for my masters.
That’s when I learned all the things you don’t hear from the 3am infomercials.
Lessons like don’t neglect putting together a good team that can help you with maintenance and management. I also learned that a cheap house is no substitute for a quality neighborhood and the headaches you get with letting your tenant background checks slip.
Don’t get me wrong, even if real estate rentals are not the passive income source you hear about, it’s still a great investment and I still own three rentals. I’ve averaged just over 15% return on the rental properties I ended up selling and make about half that in cash return on the ones I’ve kept.
Residential real estate may come with more headaches and management, but your hard work is rewarded with returns.
Pros of Residential Real Estate Rentals
Residential rentals tend to be less expensive. A median home value of $153,000 nationwide means most investors can find something for as little as twenty- or thirty-thousand down.
Returns vary but in my experience, residential tends to offer higher returns compared to commercial property. I can generally expect 15% total annualized returns or higher on rental homes while commercial properties have been in the 8% to 13% range.
Residential rentals tend to be more stable during a recession. People always need a home but, in a recession, they may not need to rent your 20,000 square foot warehouse.
Cons of Residential Real Estate Rentals
Residential can be a headache to manage. One of my best tenants – ok, one of my longest-paying tenants, used to regularly call me over to light the pilot on their water-heater. Home rentals is definitely a biz where you’ll ‘sweat the little things’.
Home rental tends to be on shorter contracts and require more frequent evictions. People move around more than businesses. It’s not uncommon to have a business tenant stay put for years while your residential houses turn over every year.
Investing in Commercial Property, the Forgotten Investment
Saying ‘commercial property’ can give you the impression that it’s all the same. The fact is, there are five major property types with some big differences between them.
Hotel and Leisure tends to be more cyclical around the economy and require more management.
Office includes everything from renting entire office buildings to renting a cubicle space.
Warehousing and industrial can mean be less management intensive but also lower returns if you’re renting out less value-added property
Storage is the least management intensive and can include owning an entire self-storage park or just renting out individual units.
Retail has been a tough spot over the last few years but can still offer solid returns for good store locations.
While not as common in residential rentals, lease terms are hugely important in commercial property. Tenants sign commercial leases for terms ranging from only paying a base rent (full service) to paying for all property costs including maintenance and taxes (triple-net or NNN). I have all but one of my commercial properties on that NNN-lease where the tenant is responsible for all costs and pays into an escrow annually. All I do is collect the checks!
Of course, your return on a commercial property will vary largely on those lease terms. If tenants are expected to pay maintenance and other costs, they’re going to want a lower base rent in compensation.
I know, commercial property investing can seem overwhelming at first. While most investors feel comfortable with the basics of renting a house out, commercial property is an entire lexicon of terms you might not know. This is where joining a local real estate investment club can be a big help in learning the ropes as quickly as possible.
Pros of Commercial Real Estate Investing
You get a greater sense of diversification with commercial property, investing in different property types or you can specialize in one specific type.
Management can be a breeze depending on how you set up your lease terms.
Commercial tenants tend to lease for longer terms. I have one tenant on a five-year lease that has already re-upped once.
Cons of Commercial Real Estate Investing
Commercial property tends to be more expensive than residential and you’re more likely to need a large down-payment to qualify for a loan.
Commercial property tends to get hit harder in recession with vacancy rates soaring and even good tenants needing some form of rent assistance.
As with most investments, the mixed-approach is usually best and the one I use. By investing in both commercial and residential, I get higher returns but can keep my time managing properties to a minimum. Build out your perfect portfolio with a mix of residential and commercial, including a few different types of commercial property, for that ultimate diversification from whatever the economy throws at you.