Is it Better to Invest in Residential or Commercial Real Estate?

Is it better to invest in a commercial or residential property? The answer isn’t as straightforward as choosing to rent out a business or home. Each type of property investment comes with its own risks, tenancy options, financing and tax implications to consider.

What is “better” ultimately depends on your financial situation and what kind of investments suit your portfolio. In this article, we’ll take a look at the difference between investing in commercial real estate vs residential real estate so you can consider what’s right for you. 

Note: This article is for personal education purposes only. Always speak to a financial advisor or tax professional to get personalized advice for your situation before making any decisions about where to invest your money. 

Investing in commercial vs residential real estate — what’s the difference?

Residential real estate is any property or unit used as a home, such as single-family rentals, condos, or apartments. It requires purchasing (or inheriting) a home and then renting it for monthly income, usually under a lease agreement of around 12 months. This is the preferred type of investment for most individuals because obtaining finance to buy an investment home is fairly straightforward, with a lot less red tape to contend with than commercial finance. Most houses also appreciate well over time and it even gives you the option of returning to the home to live in yourself one day. 

In a recent article, Roofstock reported that single-family rentals (SFRs) have provided nearly identical returns to the stock market — but with far less volatility. This makes owning a rental property an attractive investment option to build or diversify your portfolio. 

Investing in residential real estate might suit you if:

• You are new to real estate investing or are looking for a stable, less complex investment type

• You want flexibility, with an option to adjust rental prices and sell the home or return to live in it yourself one day 

• You want control over your asset, with the option to manage the property yourself or choose a company you trust to work with, such as Belong or a property management company

• You want to take advantage of the tax benefits for landlords, such as deductions for expenses and mortgage interest or deferring capital gains

Residential real estate investing is also a great option for people who want to own property, but can’t afford home ownership in the area they want to live. Known as ‘rentvesting’, it involves buying an investment property in a more affordable, up-and-coming area and renting it out, while continuing to rent your primary residence in your preferred location or home type. 

In commercial real estate, the tenants renting from you are using the space to conduct business. The leases are much longer (around 5-10 years is common) and instead of attracting a monthly rate based on how many rooms the property offers, they are typically quoted as a yearly rate based on the square footage available to the business. The workload of managing a commercial property will vary greatly depending on the type of space and leasing business/es. For example the tenants' needs in an office space will differ to a business operating a restaurant or even a hotel, which is a 24/7 business. 

Investing in commercial properties is usually recommended to more experienced investors. This is because the process is complex, it takes a lot of capital, and there are more hoops to jump through to get finance. Commercial real estate is often owned by other corporations or a group of investors, but it is possible for individuals to own commercial real estate for investment purposes.

Investing in commercial real estate might suit you if:

• You are an experienced real estate investor looking for a long-term investment option with higher risk and higher reward potential

• You are a high-net worth individual or are working with a group of investors, since investing in commercial real estate requires more capital than residential real estate

• You can afford the higher maintenance and running costs of operating a commercial property, especially if a change in tenants requires reconfiguring the space

• You want to take advantage of tax benefits such as depreciation, mortgage interest deductions, and 1031 exchanges

• You have a good team of professionals to guide you through the legalities and regulations of investing in commercial real estate

A popular alternative for individuals interested in commercial real estate is to buy shares in a publicly traded Real Estate Investment Trust (REIT). These companies own, operate or finance the properties to generate income on behalf of investors, so you won’t need the same specialist expertise — but you also won’t own the property or benefit from capital appreciation. 

How investing in residential real estate makes money

Investing in residential real estate can make money in three ways:

1. Passive income from gross rental income
2. Appreciation of the property over time or ‘flipping’ the home after it’s been renovated
3. Tax deductions and benefits such as depreciation and deductions for mortgage interest and expenses

For most investors, positive cash flow is the goal — owning a home that earns more than it costs to own and operate. How much you earn on a rental after expenses is known as ‘net operating income’ or NOI. This involves taking your gross rental income and subtracting your gross operating expenses and debt liabilities. You can learn more about how to do an accurate cash flow analysis on a rental property here.  

The alternative is negative cash flow on a rental property means that the home doesn’t produce enough cash to cover the cost of the asset. While the name makes it sound, well, negative — this can sometimes be a strategic move. Known as ‘negative gearing’, some real estate investors will take on a property knowing that the rental income won’t cover costs of expenses in the short term. This is because the asset will appreciate and may produce more money in the long term. Negative gearing can also reduce tax liability, with losses claimed against other sources of income.

This is a riskier strategy than positive cash flow, as it requires investing more of your own money for the larger payout in the end. There are also capital gains considerations on the profits if you sell the property without reinvesting the money into another similar home. 

How investing in commercial real estate makes money

If you are a direct investor in commercial real estate — that is, owning the physical property — you can also make money in the same three ways, but on a different scale:

1. Through annual rent from your commercial tenants, with a steady income on long leasing arrangements
2. Through appreciation of the property as its value increases over time, delivering capital gains when sold
3. By reducing your tax liability, as commercial real estate has similar tax benefits to residential such as depreciation, mortgage interest deductions and 1031 exchanges

If you choose to invest in a Real Estate Investment Trust (REIT), the above won’t apply. That is because you will not own any commercial real estate as an individual, nor can you access capital appreciation or tax strategies that real estate ownership attracts.

There are three types of REITs for investors:

• Equity REITS: Companies that own and manage real estate, generating income through rent.
• Mortgage REITS: Lenders that finance real estate projects through mortgages and loans, generating income from interest.
• Hybrid REITS: Companies that offer a mix of both equity and mortgage REITS.

The main benefit of investing in an REIT is that shares remain liquid as they don’t rely on you owning, maintaining and buying/selling a physical property. But that benefit can also be a drawback if you’re looking to take advantage of the benefits of real estate investing. If you invest in property, you can access monthly rental income, you’ll own an appreciating asset that can be sold down the track, and you can take advantage of tax strategies to reduce your tax liability each year.

How Belong is simplifying residential real estate investing

If you’re considering an REIT over investing in real estate because you’re put off by the amount of work it takes to manage and maintain a property, you’re not alone. But there’s also another option to consider: letting Belong take care of everything.

Belong wants to bring residential real estate investment back into the hands of individual investors, helping homeowners to achieve financial freedom. We do this by making the process of managing a rental home and achieving passive income much easier, where homeowners don’t have to lift a finger. Our homeowners even get asset management advice, helping to optimize your investments and get the highest ROI. 

So whether you’re ready to try your hand at investing in residential real estate or are looking for better ways to optimize your rental’s cash flow, learn more about Belong’s new approach  and see if your home is eligible here.