“Residential” vs “Commercial” Real Estate Investment

When considering your buy and hold real estate investment strategy, an intermediate investor may get to a crossroads after completing a couple of deals: “should I continue to buy 1–4 family residential real estate, or should I scale up into 5+ unit commercial deals?”. This post aims to demystify why so many investors stay in small deals and why so many scale into commercial.

• 1) Value control: A key difference between 1–4 unit deals and 5+ unit deals (considered commercial), is that the former is valued based on “comps” and the later is based on “NOI”. A comp is easy to understand, the value of my property is based on what comparable properties on my area selling for. Outside of forcing equity through improving the condition and adding bed/bathroom count, there isn’t a ton you can do to boost the value. Values in commercial real estate are similar to how business are valued, ie based off income. Net operating income is essentially unlevered profit. What would my property cash flow with zero debt after removing expenses (tax, insurance, maintenance, vacancy, utilities etc). Buyers take that income level and divide it by something called a Cap Rate to come up with a property value. If the market standard is a 7% cap rate and your building has a $30,000 NOI, the value will be $430k (ie 30000/0.07). When a cap rate “compresses” or lowers, values go up, when a cap rate expands, values go down. Caps tend to be affected by macroeconomics such as the interest rate environment, popularity of a market etc. However, if you assume a stabilised cap rate through your hold period, you can build equity through growing the NOI. NOI can grow in two ways, increasing income or lowering expenses – two things that investors can certainly attempt to control.
• 2) Complexity of financing: 1–4 family real estate is typically financed by Fannie/freddie backed mortgages. You can put as little as 3% down and your ability to borrow is oftentimes linked to your personal income and debt. Commercial financing tends to use DSCR (Debt Service Coverage Ratios) to analyse if the asset will produce enough income to repay the loan. Commercial financing also tends to be more relationship focused, accounts for borrower experience level, may be slightly more expensive than residential financing, and may provide more flexible terms.
• 3) Audience: Residential real estate generally has a wide target audience or homeowners and investors. This form of real estate is popular for primary residence buyers, investors and house hackers (living in the property whilst renting a portion out). Commercial real estate is only purchased by investors, so the marketability for onward sales typically has a smaller universe.

There you have it. There are certainly more differences and nuances between the two property types, but value control, financing and audience are 3 of the key things to be aware of when moving from residential to commercial real estate investment.