Is Commercial Better than Residential? The Dirty Secret
As the world continues to deal with massive stock market fluctuations, more and more investors have decided to invest in real estate as a source of portfolio stability. And, for most new investors, the entry into the real estate world involves buying residential properties, as this seems like the easiest path.
But, commercial real estate investing is not an insurmountable obstacle, and making the transition from residential to commercial provides investors significant advantages.
In this article, I’ll provide an overview of commercial real estate and discuss why switching from residential to commercial makes sense.
Commercial Real Estate Overview and Strategies
In analyzing commercial real estate options, one of the first items investors need to address is their particular commercial niche. Defining one’s commercial real estate niche broadly involves selecting A) property category, and B) investment strategy.
With respect to property category, it helps to take a step back and outline the differences between the residential and commercial real estate umbrellas. Residential real estate includes all single-family homes and one- to four-unit “plexes.”
On the other hand, commercial real estate includes the following six sub-categories:
● Multi-family residential (five units or more)
● Office Space
● Industrial
● Medical
● Hospitality
● Retail
In conjunction with selecting a property type, investors also need to determine a commercial real estate investment strategy, which include the following major options:
● Traditional development
● Commercial BRRRR (a.k.a. value-add)
● Long-term buy and hold
● Owner-occupied buildings
● The land-bank model
While making these decisions may seem overwhelming to new investors, commercial real estate professionals can walk you through the considerations associated with the best property types and investment strategies for your situation.
And, with an understanding of these commercial real estate considerations, I’ll outline in the remaining sections three reasons why commercial real estate represents a better option for investors than its residential counterpart.
Larger ROI with Commercial Real Estate
The primary reason commercial real estate proves superior to residential comes down to profitability. Bottom line, commercial real estate offers far larger returns on investment (ROI) than residential real estate.
In a nutshell, the more capital you can raise for a particular deal, the more you can amplify the returns on your contributed capital. With residential real estate, investors are largely limited to traditional lenders (e.g. banks and mortgage lenders) and private lenders, which places a ceiling on borrowing.
With commercial real estate, investors have far more options for raising capital - both debt and equity - significantly increasing the scale and returns of potential deals. From pooling capital to syndication to joint ventures, commercial real estate just offers more options to raise more capital, driving larger ROI for investors.
Local commercial real estate professionals can help you identify ideal capital structures for your market and unique situation - need help finding reliable ones in your area? Drop us a note!
Commercial Real Estate and Guaranteed ROI
In addition to larger ROI, certain commercial real estate deals create counter-cyclical demand, which essentially guarantees investor ROI. Specifically, investing in self-storage properties, investors buy into a type of real estate that thrives regardless of economic situation - and tends to perform better when the economy struggles.
Two particular characteristics of a recessionary period tend to increase demand for storage units:
● The back-to-school effect: College enrollment tends to increase during recessions, as more people go back to school to improve their job prospects. When this happens, people need a place to leave all of their stuff, and storage units often become the preferred temporary solutions.
● The downsizing effect: Economic downturns often coincide with downsizing, that is, moving from a larger space to a smaller one to reduce monthly housing expenses. Rather than throw things away, downsizers tend to instead store furnishings that don’t fit into their new, smaller homes, leading to another boost in storage unit demand.
While nothing is completely guaranteed in real estate, investing in self-storage properties provides investors an option to hedge against economic downturns and maintain solid ROI, a technique not available with residential real estate.
Feel free to drop us a note if you need help finding self-storage property investment opportunities in your market. We have a network of local professionals and are happy to help!
Forced Appreciation with Commercial Real Estate
The final major advantage of commercial real estate over residential involves property valuation and appreciation.
With residential real estate, property valuations rely on market comps - or comparable sales and listings in the local market. As such, you can’t really do much to improve the value of a residential property besides wait and hope.
With commercial real estate, appraisers use an income-approach to value properties. Specifically, commercial property valuation equals net operating income (NOI) divided by the market cap rate.
While the market largely dictates cap rates, investors can increase the NOI of a commercial property and, in doing so, increase the property’s value - a process known as forced appreciation.
Final Thoughts
As with any investment, investors should conduct thorough analysis and due diligence prior to diving into a commercial real estate deal. However, as the above article illustrates, commercial real estate includes significant advantages over residential. And, when you’re ready to make the jump, here are six great options for investing in commercial real estate.
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We recognize that, even after outlining the above information, tackling the challenges of transitioning from the residential into commercial real estate world can seem daunting.
That’s why we’re here to help. The Pocket Broker team lives and breathes commercial real estate, so drop us a note to see how we can help you achieve your unique objectives!