The age-old question…
Novice property investors traditionally want to know, “is residential property investing more profitable than commercial?” And the trite answer is a simple, “yes.” That’s why most heavy-hitter property investors would rather place their funds in commercial properties. In terms of return on investment (ROI) the ROI of commercial property is usually much greater than any residential investment can throw off. And most experienced commercial property investors know this implicitly.
Key differences between commercial and residential investments
One of the reasons experienced investment pros like to invest in commercial property, is that it yields a greater profit than residential. You’ll find that your risk is greatly diversified due to the larger overall number of tenants in a given property (especially in office and retail buildings). So, if one of your tenants leaves by going out of business, for example, the other tenants in the building will easily help to pay your total expenses on the building until you’re able to find and install a new replacement tenant. If you have a two or three-family house, when a tenant leaves, you’re much more exposed financially – either one-third or one-half of your rental income can be lost overnight, and you’ll certainly be scrambling to find a replacement tenant as soon as possible.
Differences between tenants
Compared to residential tenants, business tenants scrutinize their location thoroughly, and put a great deal of time, money and effort into their selection process. After all, they expect to be a thriving concern, one that will stay in place for many years. They will also be most probably making improvements and changes to the interior of their space to fit their particular needs, be it a retail operation, or office space. For example, an office tenant may want to redesign an entire floor of commercial office space to put in cubicles, rather than many interior offices. They may want a bullpen area, a separate dining area, etc. All these will require an investment that they will amortize over the period of years they intend to be in the building. The same cannot be said for a residential tenant. They might put up bookshelves. And that would be a stretch. You get the difference…
Commercial property leases
As such, commercial leases tend to be much, much longer than any residential property lease. In residential, a two year lease would be considered long. In commercial, a two year lease is almost unheard of – it would be way too short a time for a commercial tenant to recoup their improvement costs. Typically, commercial leases can be between five and ten years in length, with options for yearly renewals, with rent bumps included. In addition, commercial leases tend to be triple-net. So unlike residential tenants, commercial tenants will pay for their own utilities, and their portion of the building’s insurance, taxes, repairs and other maintenance charges. This too is unheard of with residential leases.
Commercial vs residential property valuating
When appraisers research residential properties, they use the comparable sales approach to help create a market value for any given property. Not so with commercial properties. An appraiser can use comps to help aid in his research, but he traditionally uses the income approach to appraising to evaluate the market value of a commercial property. With this approach, the appraiser looks closely at the net income for each tenant in the building, then comes up with an overall amount per square foot that’s currently available in the building. This will yield his final market valuation for the property. In addition, when lending, banks tend to require heavier down payments (starting at thirty percent loan-to-value ratios) for commercial building investors. Residential properties may only require twenty-five percent loan-to-value minimums. When shopping for commercial loans, be sure to be cognizant of these key differences.
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