Commercial vs Residential real estate: Which is a better Investment.

When people start discussing real estate investing their thoughts naturally turn to the residential model. Buy house, rent house and eventually sell the house for a profit. It's what we are comfortable with because we have all owned houses and it works. Most people are under the impression that investing in commercial real estate requires too much upfront capital. Because of that far fewer people think about the commercial model when they think about real estate investing. The truth is that in many cases an investor can get into a commercial real estate investment for less capital than they could a residential deal. I will explain how that's possible later in this post.

So where is the dividing line between commercial and residential real estate investments? Lets define that based largely on how banks look at it. A residential deal would be a property with less than five units to be occupied by individuals as their primary living space. Commercial is five units or more meant for individual occupancy or any property with a non residential use. Restaurants for example. In both of these models we are looking at passive investment. None of these models involves investors quitting their medical practices or law firms to collect rent or fix broken toilets.

Quick takeaway. Investing in commercial real estate can be totally passive.

So is commercial really better and why? It depends a little bit on the investor and a little on the deal. I personally look at both commercial and residential and consider both to be viable investments. I have a slight bias towards commercial and here is why. Reason number one. I control the property value.

In a residential property the value is largely determined by three factors two of which are location related. The first factor is area com-parables or comps. This is a comparison of like properties in the area and what they have sold for recently. For investors the other factor is local market rental rates. Your 2500 sq ft rental home is not going to rent for much more than the 2500 sq ft rental home across the street.

As you can see both of these factors are location related. The third factor is purchase price and condition. One can buy a property in need of maintenance for cheap and invest the money to fix it up or you could buy a property in a good state of repair ready to produce revenue. Possibly with tenants already in it. The fixer upper you will get cheap and the turn key home you will pay close to market price for. I lean towards turn key instant revenue investments myself. Two of the three factors you have little control over. So how are commercial properties different?

The value of a commercial property is determined by revenue produced. Any increase in revenue or reduction in costs increases value. Let me give you an example. Two properties to consider. The first is an office building with class A office space. Its a beautiful building that you would certainly be proud to own. Property number two is a warehouse on the other side of town build several years decades ago. Located in a part of town that you and I would not normally go to. Which one is worth more? To answer that we look at revenue. The beautiful class A office building has a high vacancy rate and thus low revenues. Additionally, the cost of maintenance is quite high.

The old ugly warehouse on the other side of town has been continuously rented by a tenant for light manufacturing for decades and consistently producing revenue. Who wins? The warehouse does. OK so more revenue more value. What does that mean to an investor?

Quick take away. In commercial real estate the investor controls value.

It means that we as investors control value by controlling cost and revenue. Lets consider our hypothetical office complex and apply a little creativity and smart business practices. Lets say that a group of savvy investors purchased the property. The purchase price was based on the buildings current revenue minus operating costs. The investors realized that although there was nothing wrong with the property it was being marketed as just office space in an area where there was already a generous amount of office space available. The investment group took the time prior to purchase to study the surrounding community to see what needs could be fulfilled to make the property more attractive. Here is what they learned.

The property was new and located on the northern edge of an affluent community in Texas. Not far from the property was a satellite court house and a major hospital. Based on this study the group did the following. The inexpensively divided some of the interior space to a central greeting area and office support center. They then subdivided the perimeter offices into individual professional suites. This formed a low cost office solution for professional attorneys and doctors looking to start a practice in the area. These two professions were identified as under served within the community.

Because of its southern location the utility expense for air conditioning was quite high. This was addressed by using a combination of federal incentives and a low interest loan through the 504B program to install a solar array on the rooftop. This significantly reduced the electrical expenses for the buildings common areas and and the excess electrical power was offered to prospective tenants to encourage them to lease office space. Interestingly, this addition of solar panels also was structured in such a way that offered exceptional tax savings for the investors. Whats the bottom line? Increased occupancy resulted in increased revenue. The addition of solar significantly reduced cost with little to no cost to the investors. As result the building is worth more and the revenue stream is consistent. I know what you are thinking. That's great but I do not have millions in investment capital to devote to a project such as this.

Quick take away. Commercial real estate can be easier to get into than residential and both can be passive investments.

Previously that is exactly what you would need. But now the laws have changed and the playing field has been leveled for the average investor. Its called the JOBS Act and allows small investors to pool a series of small investments together and as a group invest in exactly this type of investment. Sometimes for as little as a hundred dollars. Additionally, when structured properly these investments have no underwriting obligation for the investors. That means you do not have to guarantee any loans. You as the investor decide how much or how little you want to invest.

John Larsen is the managing partner of Eco7group and has a passion for the environment and real estate investing. He takes great satisfaction in teaching other investors how to be successful. Learn more at eco7group.com