Investing in Real Estate – Should You Buy Residential Or Commercial character?
We hear this often from real estate investors: “What’s the smarter move? Residential or commercial investment character?” It should come as no surprise that there isn’t a one-information answer to this question. You’ll arrive at your best choice — the one that maximizes your chances for success — by working by a decision course of action that includes some “global” issues, some local and some that are thoroughly personal.
Let’s start with some terminology. For the purposes of our discussion, we’ll define as residential any character 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. (FYI, the tax code classifies any character in which 80% or more of the gross income comes from dwelling units as residential, so many mixed-use similarities can be classified as residential for tax purposes.)
For commercial character, we’ll use a typical layman’s definition: character that derives its income from non-residential supplies, such as offices, retail space and industrial tenants.
Why do I say that this is the layman’s definition? Because appraisers and lenders would consider large (>4 unit) apartment buildings to be commercial investment character since they are bought and sold strictly for their ability to produce income and not as a possible personal residence for the owner/investor. However, it will suit our discussion better to treat all apartment buildings as residential similarities.
What are the global issues that should affect your choice to buy residential or commercial character? 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 careful regarding commercial character. 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 need 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 ineffective economy — can take longer than it might in unstressed economic times. 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 and availability of financing. Interest rates are always important to investors, but there is one situation that may strike you as counter-intuitive. When home loans are freely obtainable and 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 and easy credit often average that individuals can own a home at a monthly cost that is the same — or less, after taxes — than renting. So part of your possible tenant pool may be lost to home ownership.
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 average that commercial space is always in short supply in a particular location, recession despite. And the cost of single-family homes in your community may be so high that there will always be a strong need for rentals. Think globally but act locally (with apologies to environmentalists for borrowing their slogan).
You could buy a character 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 character yourself, how would you know if the management firm is doing an permissible job? Most investors begin as hands-on managers and your chances of success will be greater if you choose a kind of character 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 first-time investors often lean toward buying a small residential building. You may not know the fine points of leasing and landlording, 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 change. You already have firsthand knowledge of how commercial lease deals come together, and what the parties typically expect of each other.
The Pros and the Cons
Like any of your investment choices, each kind of character has its pros and cons. For example:
1. Residential units are generally easy to rent. Turnover in housing is high, so your pool of possible tenants tends to be large.
2. Leases are generally short, especially for apartments, so you can keep speed with the rental market. This method cash flow tends to be fairly strong with a multi-unit residential character.
3. Financing residential character is usually fairly straightforward. For smaller similarities, the time of action is similar to financing a home.
4. The cost per unit tends to be lower for residential than commercial. The more units you have, the less likely it is that a vacancy will severely impact your cash flow.
5. You could live in one of the units of a multi-family character. clearly it’s easier to keep an eye on the character if your eye is truly there.
1. Residential similarities usually require a lot of hands-on management.
2. Residential similarities usually require a lot of hands-on management. (That’s not a typo. I said it twice.)
3. With a single-family home, one lost tenant equals 100% lost rent.
4. Multi-family houses tend to be older and consequently may require more repairs and maintenance.
5. Residential tenants don’t keep office hours, so you can get a call or complaint at any time of day or night.
6. Larger multi-unit similarities generally have a lot of traffic in shared areas and will require greater upkeep.
7. Did I mention that residential similarities usually require a lot of hands-on management?
Dealing with commercial tenants is quite different. Ideally, it’s business, not personal. You may require a personal guarantee on a lease, but you should expect to have more of a business-to-business relationship.
1. Typically leases are longer, with built-in rent escalations. Five years, with options to revive is not universal but certainly quite shared. Except perhaps for small offices, few businesses would be willing to go to the expense of becoming established in a particular location without a guarantee of more than just one year.
2. Many commercial leases pass by to the tenant a pro-rata proportion of certain expenses (or a pro-rata proportion of the increase in certain expenses, over a base). For example, the tenant may be obligated to pay its pro-rata proportion of character taxes and shared-area maintenance. This helps stabilize the cash flow for the landlord and makes that cash flow more predictable.
3. Management is less hands-on than with residential. Renewals are less frequent. Many commercial leases are written to include the requirement that the tenant be responsible for interior repairs, HVAC maintenance, glass breakage, etc.
4. Depending on the kind of space (i.e. more shared with retail and high-end office), the tenant may fit-up the space to suit itself. The landlord may give a one-time fit-up allowance or a period of free rent, but the interior finish then becomes the tenant’s responsibility to continue.
5. Because the character’s value is strictly a function of its income stream, you have the opportunity to create value by enhancing that income stream. In other words, you don’t need to rely on general market “appreciation” to increase the value of your character, but can take steps to do so yourself.
1. Trying to buy a commercial character on a shoestring may not be a realistic plan. Lenders are generally tougher underwriting commercial loans, especially if you have no experience operating commercial character. Down-payment requirements tend to be higher, as do interest rates. Loans are for shorter terms and often have a “balloon” requirement (i.e., must be refinanced before the moderate end of the term). The character will have to pass muster in terms of its projected cash flows and debt coverage ratio.
2. Leasing a commercial space can take much longer than leasing a residential unit. After a tenant is identified and basic terms agreed upon, it is usually necessary for attorneys for both sides to negotiate the language of the lease. The complexity and cost of this course of action can vary greatly, depending on whether you are dealing with a local or a national tenant.
3. Filling a vacancy can take much longer than with a residential unit. Commercial leases will typically require that a tenant exercise an option to revive well before the lease expires — perhaps six to as much as twelve months prior — so that the landlord can have abundant time to look for a new tenant.
4. Financing commercial character can be more complicate than with residential. You’ll need to demonstrate to the lender that the character will perform at a level that can can cover the debt service with room to spare.
5. If you don’t have experience being a commercial tenant, then becoming a commercial landlord may require that you get familiar with some concepts and skills that are particular to the commercial world. You’ll want to learn about “tenant mix” if you own retail space, about commercial insurance and about the billing and reconciliation of pass-by expenses.
While there is certainly no right answer to the question, “Residential or commercial?” there is probably a best answer for you. Do you want the hand-on involvement of residential? Do you have the resources for commercial? Do you want the possible for higher cash flow, and with it the possibility of greater risk? Do you prefer a more modest but more predictable return? Consider your objectives and preferences carefully, and estimate your resources — time, money, skills — realistically. With a bit of luck, the answer should jump off the page.