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Commercial vs Residential Real Estate Investments

Whether you buy Commercial-use or Residential-use Real Estate as an investment, you are none-the-less conducting a commercial activity subject to licensing laws, inspections, building codes, taxation and reporting, Vendor 1099's, HUD, FCRA, FTC, and the myriad of other State and Federal laws relating to your commercial activity. The fact that you lease a property zoned either commercial or residential has mostly to do with how you structure a lease and the specific laws and ordinances that apply. In the end, however, when you lease ANY type of property, you are engaging in a commercial activity, and must play by the rules.

For investors in Residential Use Properties, you in fact have many more Landlord-Tenant Laws that must be followed in Minnesota, and there are many things that are binding by State Statute and cannot be waived by the lease agreement (i.e. Habitability statutes). Hence the Residential Investor has more on his or her plate in terms of Management than the typical Commercial Property Investor who delegates Maintenance and Repairs to the Tenant.

Many independent Landlords are unfamiliar with the new Small Business Jobs Act enacted by Congress that requires ALL recipients of rental income from real estate to issue Forms 1099 to service providers for payments of $600 or more during the year. The act subjects recipients of rental income from real estate to the same information-reporting requirements as taxpayers engaged in a trade or business.

As you can see, Landlords are conducting a commercial activity when renting ANY kind of real estate, so it is important to understand that most independent Landlords benefit greatly by hiring a Property Management Company to help them comply with the laws and reporting requirements.

Valuation (Commercial vs Residential Properties)
Residential Use properties are generally evaluated and valued according to underlying comparable value of the surrounding homes in the area. Whether or not the home is leased or vacant makes little difference to the underlying value of a home. The value of the Residential home will be determined by the actual Sales of near-by homes, adjusted for the square footage, lot size, and quality and characteristics of the structure.

Most Commercial use properties, however, are valued using a Return-On-Investment (ROI) or other income generation criteria. This could be Capitalization Rate (Cap Rate), which is very common, or gross rent multiplier (GRM) or various other means. "Cap rate" is probably the most common, especially when evaluating Multi-unit properties.

The Cap rate of an income producing property is simply the whole-dollar cash-on-cash return on investment each year after operating expenses and before financing costs. What this means in Commercial investments is that they are much more sensitive to the quality of the tenant, rent rates, vacancy rates, lease terms, economic factors, etc. Generally speaking, commercial investments should have positive cash flow at the time of purchase and will be valued accordingly. Sometimes the properties will be sold according to projections, replacement cost, etc., but whether you are acquiring a new office condo or a tenanted industrial warehouse, you'll definitely want to evaluate the return of the invested capital using any of the various valuation techniques so you can truly understand your ROI.

Financing (Commercial vs Residential Properties)
Financing a property being acquired for Investment use is significantly different than residential owner occupied financing. When financing a Commercial Use Property, you will need to use a commercial lender because they can properly evaluate the income producing potential of the property, and hence the risk and appropriate interest rate of the investment loan. Commercial lenders will be more interested in the investment opportunity than your personal credit worthiness, but generally will attempt to link your personal guarantee anyway to guarantee the loan.

With a residential-us investment loan it is the reverse of that…your personal (or LLC) ability to qualify is of paramount importance. Most Residential Mortgage Brokers also make Residential use Investment Loans for this reason.

Many Commercial Use Real Estate Investors are surprised at the size and quality of the commercial investments they can qualify for because they are basically letting the property do the qualifying. With established tenants, a good cash flow track record, and structure in good repair, it is actually very easy to establish a supportable cash flow projection that would justify financing. None-the-less, Commercial use property financing generally requires more "skin-in-the-game" from the investor in the form of a down payment. Most commercial lenders require a minimum of 25-30% down on a non-owner-occupied Commercial property and will amortize the loan over a shorter duration (generally 15 - 25 years).

Most commercial loans are adjustable and can have a balloon payment that causes owners to refinance fairly regularly. If you're a small-business owner, you may be able to get SBA or bank financing for as little as 10% down. There are various requirements for how much space your business must use (51% or more of the purchased square footage), but that's a great way to grow the value of your business by buying more than you need and leasing the additional space to other businesses until you grow into the space, or move.

Appreciation (Commercial vs Residential Properties)
Small business owners and individual investors should definitely consider the benefits of owning their own real estate. It can be a great investment. The tax benefits, equity build-up, and long term appreciation will all help fill the bottom line like no other investment can.

While Residential property values generally ebb and flow very slowly and typically rise with fortunes of the middle-class over time. They are consistent and follow relatively predictable trends historically. The National Association of Realtors generally states that Residential Home values typically double every 10 years over that last 80 years (of course this has not been true recently).

Commercial Use investments will usually be more sensitive to economic conditions and local business health. In a down economy you may have to sustain extended or unexpected vacancies. Your carrying costs will be higher and you need to account for this in your investment plans. Generally however, you will have offsetting benefits like initially positive cash returns, significantly longer tenancies (often decades), automatic rent increases and revaluations, lower maintenance requirements and commercial tenants (businesses instead of individuals). Whatever strategy you use, stick with it over a long period. There is definitely an education involved, but the returns and expanded opportunities will be well worth it.

Find a great Property Management Partner and go for it!


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