Choosing your first investment property is one of the most significant decisions you’ll make. The right asset can provide you with the capital and experience necessary to continue making strategic investments. Unfortunately, the wrong choice can become a money-eating boondoggle, tying up your liquidity for years to come.
The question is simple: Will you buy a residential or commercial property?
The critical first choice
Both residential and commercial properties have inherent benefits and drawbacks as investment assets. Residential homes for instance, have a lower barrier to entry, while commercial properties boast more stable lease agreements. Differences abound between them, which is why this is the first choice every investor needs to make.
Everything from the type of tenant you’re targeting to the type of mortgage you’re eligible for will depend on whether you opt for a residential or commercial asset. This means you have to carefully weigh the benefits of each investment type against your own objectives as an investor. You must consider the best type of asset given your specific aims and goals.
Consider the market you’re operating in. Then, collect as much data about the market’s current state, as well as its projected state. This ensures you’re making a strategic long-term investment in a vehicle that will grow your wealth sustainably over time.
Benefits of commercial real estate
Many established investors prefer commercial assets to residential ones for many reasons. Despite the higher barrier to entry associated with commercial real estate, there are several benefits worth considering:
Creative leasing options
It’s possible to offer creative lease opportunities if you’ve invested in commercial real estate assets. For instance, a triple net lease allows you to pass on the costs of operating, repairing and maintaining the property to your tenant. These agreements are often long-term in nature, allowing you to sit back and collect income based on your existing arrangement with your triple net tenant. Triple net lease agreements are most common with large, national chain companies.
You can reap significantly higher returns by investing in commercial real estate as opposed to residential. Because the cost of entering the commercial real estate market is much higher, you can command higher rents and profit margins. Additionally, your commercial building will have more space, so you can secure rental payments from a wider tenant pool. It’s often also possible to subdivide existing commercial units, depending on the type of tenant you’re aiming to attract.
Benefits of residential real estate
Residential real estate is often the quickest, most efficient way for investors to enter the real estate market. Here are just some of the benefits you can reap by investing in residential properties:
Less tenant turnover
Businesses often expand, go out of business or change locations. This means commercial real estate investors are subject to high degrees of tenant turnover unless they manage to negotiate a highly desirable lease structure. Residential investors are much more likely to maintain long-term tenants. Additionally, it’s much easier to fill vacant residential units than it is to fill vacant commercial units. You’ll experience fewer periods of vacant space at your investment property, which means more consistent cash flow.
Lower barrier to entry
It’s much more cost-effective to enter the residential real estate market, particularly for your first investment. You can purchase a single-family home or duplex for a relatively affordable rate. Because most commercial sites are, by nature, larger and more amenity rich, you’re much more likely to pay a premium if you’re planning to invest in a commercial site. It’s often difficult for first-time investors to secure a commercial mortgage. Residential tends to be more feasible for the everyman investor.
Financing and Other Considerations
It’s also important to recognize the different types of financing solutions available to residential real estate investors, as opposed to commercial ones.
Residential real estate investors can access traditional mortgage products from banks. Residential mortgages are typically issued from a financial institution to a direct buyer.
Mortgages for commercial real estate, however, are typically issued from a financial institution to a company. Because the property is zoned for business use, it’s usually necessary to sign the mortgage as an agent of a company. This can complicate the paperwork and make it a bit more challenging to secure financing for your commercial loan.
Banks view commercial real estate loans as riskier than residential ones. The amount of money they’re fronting is larger, and so is the risk of failure. They’re likely to charge higher interest rates and offer shorter loan periods. Commercial real estate mortgages are also more likely to be on a variable interest rate, which means you could see your profits grow thinner if the Bank of Canada begins to raise interest rates. It all adds up to more risk for everyone involved.
Commercial properties are also subjected to more stringent zoning laws. Certain types of commercial operations, for instance, are only allowed in certain areas. Even light industrial processes may not be allowed in zoned areas designated for retail or residential use. You may face challenges working with local authorities to identify businesses allowed to operate in your commercial property, depending on local zoning laws.
It’s worth noting that because commercial property owners have to buy electricity in bulk, you’re likely to receive a discount on the per-kilowatt hour price you pay to your hydro company if you invest in a commercial property as opposed to a residential one.
What will your decision be?
It all comes back to the simple first question every real estate investor must ask themselves: Residential or commercial?
If you have the available capital and experience necessary to invest in a commercial investment property, it may be worth your while. Try to find a piece of high-quality commercial real estate in a desirable, growing market. Then, make sure you’re double- and triple-checking everything to hedge yourself against risk.
If you’re planning on executing your first investment and are dealing with limited liquidity, you’d probably be better served by the residential real estate market, for now. No one says you have to invest in residential forever! Once you learn the ropes in a beginner-friendly environment, you can put your talents (and capital) to work for something in the commercial space.