We hear this often: “What’s the
smarter move? Residential or commercial investment property?” It should come as
no surprise that there isn’t a one-size-fits-all answer to this question; but
even if there is no universal right answer, you can arrive at the best choice
for you – one that maximizes your chances for success – by working through a
decision process that includes some “global” issues, some local and some that
are entirely personal.
Definitions
Let’s begin with some terminology.
For the purposes of our discussion, we’ll define as residential any property
that derives all or nearly all of its income from dwelling units. Single-family
homes, multi-families, apartment buildings, condos, co-ops are all residential for
commercial property, we’ll use a typical layman’s definition: property that
derives its income from non-residential sources, such as offices, retail space
and industrial tenants. Appraisers and lenders would consider larger apartment
buildings to be commercial investment property since they are bought and sold
strictly for their ability to produce income and not as a potential personal
residence for the owner/investor. However, it will suit our discussion better
to treat all apartment buildings as residential properties.
Global
Issues
What are the global issues that
should affect your choice to buy residential or commercial property? The state
of the U.S. economy certainly tops the list. If you believe we are in or are on
the brink of a recession, then it makes sense to be cautious regarding
commercial property. You will have to rely on businesses to occupy your
commercial space, and if they’re struggling to survive or simply deferring
their plans to expand, then rental rates may soften and demand for space
decline. Replacing a lost tenant – especially one lost unexpectedly (in the
middle of a lease, or the middle of the night) because of a weak economy – can
take longer than you might comfortably be able to handle. When the economy and
employment are strong, of course, you are likely to see the opposite. Service
businesses need more space, retailers open more stores, distributors need more
warehouses.
Another issue is the cost of
borrowing. Interest rates are always important to investors, but there is one
situation that may strike you as counter-intuitive. When home mortgage rates
drop, it’s not uncommon to see an increase in apartment vacancies, making
apartment buildings less desirable as investments. The reason? Low mortgage
rates often mean that individuals can own a home at a monthly cost that is the
same – or less, after taxes – than renting. So part of your potential tenant
pool may be lost to home ownership.
Once again, the coin has another
side. If the single-family home market is suffering because of high interest
rates, loss of consumer confidence, or any of a variety of other reasons such
as we saw starting in 2008, then the demand for apartments will typically be
very robust.
Local Issues
In the real world, each of these
global issues comes with a “however” attached. You need to stay on top of your
local market because that market may contradict the national trend. For
example, highly restrictive zoning regulations can mean that commercial space
is always in short supply, recession notwithstanding. And the cost of
single-family homes in your community may be so high that there will always be
a strong demand for rentals. Think globally but act locally (with apologies to
environmentalists for borrowing their slogan).
Personal
Issues
You could buy a property and then
insulate yourself from it by turning over every aspect of its operation to a
management company. But if you’ve never operated a property yourself, how would
you know if the management firm is doing an acceptable job? Most investors
begin as hands-on managers and your chances of success will be greater if you
choose a type of property that you’re comfortable with.
So, at the personal level, will
residential or commercial suit you better?
Unless you were raised in the woods
by wolves, there is a very good chance that you’ve spent most of your life in a
residential dwelling unit: a single-family house, a condo or an apartment. You
have a first-hand understanding of the rights, obligations and appropriate
behavior of a residential occupant. If you were a tenant, you probably also
know something about the roles and responsibilities of both tenant and
landlord. It is for this reason that many first-time investors often lean
toward buying a small residential building. You may not know the fine points of
leasing and land lording, but you understand the basic ground rules. This is
familiar and comfortable territory.
Of course, some novice investors
come to real estate with a background in business and perhaps as a commercial
tenant. If that description fits you, then becoming a commercial landlord may
be an easy transition. You already have firsthand knowledge of how commercial
lease deals come together, and what the parties typically expect of each other.
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