Why commercial over residential?

[Peter Tverdov]

I have an opportunity approaching in 2017 to buy a small MXU building ($500-$600k). I am running the numbers and between the high insurance rate and the much higher interest rates with shorter amortization schedules, it absolutely hammers your COC return compared to buying a 1-4 family house.

Was just looking for some opinions as to why people like commercial so much? Longer term tenant? Appreciation? Aside from finding a place under rented that needs updating, I don't know what I'm missing.

What terms do you guys generally prefer? I can't see myself accepting anything less than 25-30 year amortization.

For the record, the building I am considering is under rented, has the ability for an addition to be put on for more cash flow...but still. Just curious as to what strategy people have in the commercial space. 

[Jessica Zolotorofe]

Hi Peter! Lots to say here, so I'll try to make it (somewhat) brief and then we can chat further, if you'd like.

Nothing against residential by any means, but here is what I see as the advantage to commercial.

First, I don't find financing to be terribly different. I'm not sure why you are running into an issue, maybe the mixed use or low occupancy, but just being commercial shouldn't cause problems. 25 or 30 year amortization is pretty common, often with a shorter term and balloon at the end, but the longer amortization I haven't had the same experience. And rates are not really higher unless you are getting some kind of FHA or other assistance program on the residential, in which case you probably would have to own as an individual, not an LLC, and the more units, the more liability typically, so that's not always in the owner's best interest. As far as rates, we're closing in the high 3's, low 4's. Adjustables are running something like .5-2% above the prime. Not too different from where residential lending numbers are right now.

There are tremendous benefits to NNN or NN leases, so it depends on the types of leases presently in place in that building. Mixed use comes with some unique benefits and challenges. I wrote an article about it in a trade magazine that I have posted on my blog on here, or I can send you the link. So that's a whole different ballpark, but commercial tenants are usually, to be candid… less annoying. Less midnight "my toilet is clogged or my window is drafty" calls, less "I can't pay you this month because my sister's boyfriend's cat died and blah blah…", no "I didn't pay for renter's insurance because I didn't actually read my lease", etc. Like you mentioned, you typically get longer term leases, and unlike a residential tenant who can move their couch and bed anywhere pretty easily, commercial tenants typically improve their space in the manner required to run their business, so booths and counters and built-in shelving in a restaurant, or barber chairs and expensive built in mirrors for a salon, etc. so the likelihood they pick up and leave when they have invested in your property isn't as great. Depending on the size apartment and the rent amount, it makes sense that if someone is renting an $1,000/mo apartment and can't pay rent, that going after them for a judgment won't get you very far. Your ability to go after a commercial tenant with a personal or corporate guaranty or that runs other businesses, much more incentive for them to do what they are supposed to, and most likely you'll have a much bigger deposit than a small residential apartment.

Then there are the huge number of rules that pertain to residential landlords that don’t apply for commercial. Shorter notice periods, no adjournments of evictions for hardship, no rent control, no special rights that a residential tenant has under both federal, state and local laws, which all are extremely tenant friendly. Commercial isn’t like that.

And lastly, like I mentioned above with regard to the NN, NNN concept, you can pass through so many costs to commercial tenants in addition to their significantly higher ppsf monthly rent (again, usually, most neighborhoods…not all), like cleaning services, landscaping, signage, utilities for common areas, insurance, taxes, even re-facing a parking lot or repairing side walks can often be passed through to the tenant through "CAM" fees. Plus, you can usually require the tenant to carry their own insurance and just name you as additional insured. Commercial is just much more hands-off, less turn-over (usually), and a lot of upside.

Other people might have a totally different opinion, but before I got more heavily into residential, I worked almost exclusively on commercial development, from single free standing stores, to $100,000,000 retail centers, so maybe I just have a strange fondness for them! I do get a little bit too excited when I see a well designed strip center J Now I do both commercial and residential (investments, not personal purchases for the most part), and I have to say, that from a risk/benefit standpoint, I personally still favor commercial if you have the capital to make it work.