Differences between Residential and Commercial Real Estate Investing
How does one know whether they are ready to move on from investing in single family houses to instead investing in residential or even commercial multifamily? In order to answer this question, let’s review the pros and cons of investing in various sizes of buy-and-hold properties – namely, single family properties, small residential multifamily (2-4 units), as well as large commercial real estate properties (five plus units). A deep dive into the acquisition and maintenance of these property types can help focus an investor’s search, and bring clarity around the building blocks of a business plan.
1) Overview of Properties Types (Dwellings)
- Single family homes (SFH)
Single family homes (SFH) have the lowest barrier to entry due to their high volume of inventory and relatively accessible pricing and financing. Since this asset class can be found widely in all markets, it is often more realistic to invest within a close proximity of one’s hometown. This allows an investor to self-manage the investment property, if desired.
- Multifamily Residential Properties
Multifamily rentals are two-, three-, or four-unit residential properties. These are not as prolific as SFH but utilize the same financing structure. They lie at a unique investment opportunity intersection, spanning the gap between single family and large apartment complexes and are considered by many to be the sweet spot for profitability for new investors due to economy of scale as discussed further in the next paragraph. Additionally, small multi-family properties are not appealing to the average suburban homeowner; this reduces the demand on these properties. Multifamily owners are a discrete type of investor who prefer to steer clear of large-scale commercial properties and are not interested in scaling up.
- Multifamily Commercial Properties
A multifamily property with five units or more is considered commercial. These properties are typically more difficult to come by, but they benefit from economies of scale for both acquisition and property management. For instance, the attorney, inspection, and other professional fees for a five-plex are typically much lower than the alternative scenario of purchasing five individual SFHs.
Of equal importance is the time it would take to negotiate five separate SFH contracts and attend five closings. The same thinking applies to maintenance for larger buildings. Typically, the more units at play, the lower cost per unit for routine maintenance and property management (typically 3.5% – 10% of monthly rent depending on size of complex). This positively impacts the bottom line of the investment, yielding higher profit margins. The exception to this rule is a SFH where the tenant maintains the yard and makes small repairs as needed. The cost of maintenance in that scenario is effectively zero.
2) Vacancy Considerations
Vacancy rates are a critical piece of any investment calculation. A SFH in a good neighborhood near high quality schools often have low vacancy rates because their tenants prefer to stay longer while their children are in school. Multifamily and commercial rentals, on the other hand, tend to have more transient tenants. On the flip side, commercial rentals have a major advantage in maintaining positive cash flow. If one or two units are vacant, the other units will continue to pay rent. For instance, the vacancy rate in a five-unit multifamily is only 20% if one unit is unoccupied, while the vacancy in SFH is always 100% if there is no tenant.
3) Financing Considerations
From a financing perspective, an owner-occupied residence typically qualifies for the best interest rates because lenders consider this a low risk mortgage, and there are government backed loans such as the FHA and Veterans (VA) loan structured for this purpose. These types of low-down payment (0% – 20%) and low interest loans can be applied to residential properties ranging in size from a single family to a multifamily four-plex. Additionally, some programs allow for applicants with lower credit scores.
One downside of residential financing for an investor is the cap on the number of mortgages one can hold at a time. For a single lender, the cap is typically four mortgages per investor. However, Fannie Mae will allow up to ten financed residential properties as large as four units each per individual; this can be accomplished by using multiple lenders or reaching out to portfolio lenders.
Portfolio lenders are institutions that originate mortgage loans and hold a portfolio of loans instead of selling them in the secondary market. This allows the lender greater flexibility in the terms of the loan, including less restrictive underwriting guidelines, such as minimum income requirements. Portfolio lenders typically do not limit the number of properties or the quality of properties in the portfolio. This type of loan can be very useful for an investor looking to purchase several older properties. These loans also involve a prepayment fee, and potentially higher interest rates to offset the lender’s risk, so it is important to calculate that into any business plan before committing to that route.
The difficulty of finalizing commercial financing is its primary drawback.
Commercial loans are much harder to obtain than residential. There are higher down payments (20-30%) and higher overall project costs due to the scale of the buildings. There are also more stringent investor qualifications such as a credit score above 700, evidence of a proven real estate management track record, and a net worth greater than the value of the loan.
A partnership with a more experienced investor is often a necessity in order to start out in commercial real estate and qualify for a loan. While partnering up with experienced investors will probably decrease payout, it will increase a new investor’s chances of succeeding in a deal. Additionally, the payment structure of commercial loans can be shorter, ranging from a few months to as long as 25 years.
There is also the option of a balloon loan which has monthly payment similar to a 30-year mortgage, but over a shorter term such as five years. One final large payment of the balance is required when the loan comes due. This type of loan is useful for refinancing a prior loan when it becomes due and there are no funds for repayment. Balloon loans are best for businesses with predictable income, so that provisions can be made for repayment of the bulk of the loan at the end of the term. They can also be helpful for temporarily financing construction.
To encourage an investor to keep progressing on a project, lenders might offer a balloon payment option over two to five years. Monthly payments would be calculated as if it was a 30-year mortgage. That gives an investor time to buy land, build, and refinance with more traditional permanent financing within the shorter two to five year term.
4) Appreciation Considerations
Residential property appreciation is driven by the market comps as well as physical improvements made by an owner such as interior renovations, infrastructure upgrades, or landscaping.
Commercial properties, however, are driven by their net operating income (NOI).
The NOI is total revenue minus operating expenses. There are many factors that may influence the bottom line. For instance, a selection of a quality property manager can positively impact the value of the property regardless of swings in the market. The opposite is true as well. This gives a commercial property owner greater control over the value of their investment. For a more in depth discussion of forced appreciation, refer to “You cannot force a rain…” article.
In summary, residential properties are the easiest to acquire, while commercial properties offer the best economy of scale and control of profitability. For a new investor, a small multifamily property may be an attractive option since it has a foot in both worlds and can pave the way to expanding into larger project down the road.
This article is written in collaboration with Krista Kennedy.
