Starting with residential real estate investing is a good way to build capital and experience before moving to commercial real estate investing. Residential properties provide housing for people, commercial real estate for lease provides housing for businesses.
While the earning potential of commercial properties is high, but there are important differences between leases for commercial and residential properties.
As a result, it’s crucial that you understand the differences between renting commercial and residential real estate to maximize returns and minimize risk.
Let’s look at some key differences between renting commercial and residential real estate.
Residential Real Estate
Residential real estate provides housing for individuals, not businesses. Residential properties include:
- Single-family homes;
- Multi-family buildings;
- Housing coops;
- Duplexes; and
- Mobile Homes.
However, not all properties where people live are considered residential real estate. For instance, apartment buildings with five or more units count as commercial real estate. You can think of residential real estate as properties primarily used for private housing.
Commercial Real Estate
Commercial real estate includes properties used for business purposes. Examples of commercial real estate include:
- Office buildings;
- Retail space;
- Apartment complexes;
- Industrial sites;
- Hotels; and
- “Special Use” real estate (e.g., casinos, government buildings, stadiums, etc.).
With commercial real estate, landlords rent to businesses and other commercial entities. Hotels, like large apartment complexes, count as commercial real estate due to the sheer number of units they contain, which, in turn, dramatically raises the price of the property.
Some buildings mix commercial and residential real estate. For example, mixed-use buildings in urban centers might have commercial space on the lower floors and residential apartments on the upper floors.
Differences Between Renting Commercial and Residential Real Estate
Commercial leases and residential leases are similar in that both involve monthly payments for tenancy. However, there are also some key differences between leasing residential and commercial property.
Most residential properties have year-long rental agreements with an option to renew at the end of the lease. The typical commercial lease is between three and five years, though commercial leases can extend up to 15 years.
Longer leases for commercial real estate can be a double-edged sword: On one hand, longer leases mean a more reliable revenue stream. On the other hand, being locked in a long commercial lease with a bad tenant can be extremely frustrating.
A bad tenant might not only shirk their tenant responsibilities but also discourage other potential tenants from signing a lease. Going through eviction court proceedings to remove bad commercial tenants can cost landlords significant time and money.
Residential tenants have significantly more legal protections than commercial tenants. Most states have laws that require landlords to perform maintenance and upkeep for residential rentals and that strictly regulate eviction proceedings. Moreover, local ordinances have warrants of habitability defining minimum living conditions landlords must maintain.
On commercial leases, landlords have much more flexibility to define terms and conditions. Most commercial leases contain explicit default clauses that define when and how evictions can happen. Commercial leases also allow landlords more flexibility with setting property use conditions.
Many commercial property leases have what are called “co-tenancy clauses” that define how commercial tenants can respond to other tenants vacating the premises. Co-tenancy clauses give commercial renters the option to terminate a lease without penalty if other core tenants on the property leave.
Generally, co-tenancy clauses allow tenants to drop the lease once a defined vacancy threshold is passed. For instance, a commercial tenant might stipulate they can terminate the lease if occupancy falls below 60%.
The point of co-tenancy clauses is to protect commercial renters who might lose traffic and profit if other “anchor” tenants leave the space. Many retail ecosystems, such as malls, depend on smaller businesses attracting customers from nearby larger outlets. Commercial landlords should be aware of co-tenancy clauses and how they can affect vacancy rates.
With residential leases, the landlord is almost always responsible for repairing important systems like air conditioning, plumbing, or electrical. Tenants notify landlords when something goes wrong, and the landlord schedules the necessary repairs.
With commercial leases, tenants assume most of the responsibility for these types of repairs. For example, with a single-net lease, tenants are responsible for one of the major operating expenses (utilities, insurance, taxes) in addition to rent. With a triple-net lease, commercial tenants are responsible for all major operating costs as well as rent.
These types of net leases are great for landlords because they reduce their overall operating expenses. If you are renting commercial properties, be sure to explicitly add provisions defining who holds responsibilities for recurring costs.
Depending on the state, residential leases might be subject to rent control laws. Rent control laws restrict when and how landlords can increase rent prices. For example, New York City requires landlords to provide early written notice to residential tenants if they plan to increase annual rent by more than 5%.
In contrast, there are no rent control laws for commercial properties. Landlords can stipulate rental increases when and how they like in commercial leases. Many states discourage rent control for residential and commercial properties because they believe it would be a detriment to commercial investment and development.
Can I Invest in Both?
No rule says that investors have to stick to one or the other. In fact, many investors start with residential properties and move to commercial real estate once they have the necessary capital and investing experience.
Investing in both commercial and residential real estate can be an effective method to diversify your portfolio. But it’s crucial that investors understand how leasing structures can affect their bottom line. Negotiating a bad lease on a commercial property could end up costing you much more than a poor lease on a residential property.