Commercial vs. Residential Real Estate Investing: Chase Returns or Play it Safe?

By now, we've all heard about the house hackers who started with one rental property and worked their way up to mogul status. Anyone with a TV has watched couples and families on HGTV searching for dilapidated homes they can renovate and flip for a quick profit. In short, residential real estate investing has never been more popular or more accessible. With a few afternoon YouTube sessions, just about anyone can learn how to break into the field.

That said, commercial real estate has a special appeal. Why flip a crumbling two-bedroom and rent it to college students who will throw house parties in your brand new kitchen when you can renovate a shopping center and fill it with stable, profitable businesses that can net you thousands per month instead of hundreds?

Whether you're new to real estate investing or a seasoned pro, it's worth asking yourself whether residential or commercial real estate is best for your skills, income level, and investing style. Here's what you need to know.

State and local zoning laws determine how property in any given area can be used. Areas can be designated for industrial use, commercial use, residential use, or mixed-use.

Residential real estate is a property that is primarily used to house individuals and families. This designation includes single-family units, such as houses, and some multi-family units, such as townhouses, duplexes, triplexes, fourplexes, and sometimes condominiums and smaller apartment complexes. Generally, a building with more than four dwelling units is considered commercial property, but this can vary.

Commercial real estate is any property that is primarily used for business purposes, whether that's to generate revenue or provide a workspace. This includes retail, industrial, hospitality, office, and mixed-use buildings. It also includes larger multi-family dwellings such as apartment complexes that, while used for residential purposes, are ultimately part of a rental business.

Most people interested in beginner real estate investing get started with residential property, and for good reason. The barrier to entry is lower both financially and in terms of experience level. Down payments are significantly smaller, and certain borrowers may even qualify for down payment assistance programs that aren't available for commercial real estate. What's more, it's typically far easier to qualify for a home loan than a commercial real estate loan. It can also be easier to vet residential properties and determine whether or not they're a good investment, whereas commercial investing requires a little more knowledge of financials and business fundamentals.

There are plenty of other benefits to residential real estate for beginners and advanced investors alike. It's an uncorrelated asset, and it usually continues to perform well even during market downturns. This makes real estate one of the best ways to diversify your portfolio and protect your wealth. People always need a place to live, and that means it's usually much easier to consistently find tenants with residential properties. As evidenced by the impact of COVID-19 on real estate, commercial properties are often forced to shut down or go through long periods of vacancy during economic and other crises.

That said, residential real estate typically comes with shorter lease terms and higher turnover costs. Because you're often replacing tenants every 9 to 12 months, the cost of cleaning, replacing, and repairing things every year, as well as leaving the property vacant in between leases can eat into your returns quite a bit. Most states also have rent control laws and eviction protections (such as those exercised during the COVID-19 pandemic) that can limit the potential return on residential real estate.

Perhaps the biggest reason real estate investors branch into commercial property is its potential to generate higher returns than residential properties. Rent is higher on commercial properties, and larger buildings with more tenants give you the ability to scale up and increase profit margins. Lease terms are also much longer on commercial properties—typically 5 to 10 years—so you're often able to generate revenue more consistently and deal with fewer turnover costs. 

Of course, with more tenants comes more time spent on property management tasks like collecting rent and routine maintenance. That said, some commercial lease terms place the responsibility of maintenance, insurance, and other time-consuming and costly burdens on the tenant rather than the investor. 

There's also less competition in commercial real estate. Residential real estate is booming, so good deals can be hard to come by. Figuring out how to invest in and flip residential properties is much easier now with the proliferation of content, from YouTube videos to HGTV, explaining how to do it. Commercial real estate, on the other hand, is still fairly inaccessible to many investors, so you can often get your hands on sweet deals more easily.

However, there's less competition for a reason. The initial cost of investment is much higher with commercial real estate, and it's hard to secure financing. Commercial property loans tend to be pretty strict and may require that you show a positive track record with residential real estate first, on top of putting more money down. It's also a riskier investment, as it can be harder to find tenants, and commercial properties are more likely to be impacted by poor economic conditions.

If you're new to real estate investing, or even if you have a handful of residential properties, it's hard to break into commercial real estate investing. Commercial real estate deals are harder to source, and often they require you to be an accredited investor. Analyzing commercial properties to decide if they're a good investment is also a lot more complicated, and since the risk level is higher with commercial real estate, it's crucial that you know how to exercise proper due diligence. The initial investment is also very high. For most investors, residential real estate will present a more realistic and viable investment opportunity than commercial real estate.

That said, investors with the credentials and money to invest in commercial real estate often prefer it to residential. The risk level is higher, but it's easier to find good deals thanks to the lack of competition, and the return on investment can be very high if you're lucky. While average returns are similar for residential and commercial real estate, high-end returns for commercial real estate well surpass what's possible in residential real estate. Commercial real estate can also be less of a headache for investors thanks to the long lease terms and more hands-off management of tenants.

If you want to gain experience in commercial real estate but don't yet have the experience needed or the funds to drop a six-figure down payment, there are other ways. Here are a few.

Real Estate Investment Trusts (REITs) let you invest in real estate similarly to how you invest in stocks, and some focus specifically on commercial real estate. A REIT is essentially a company that owns a lot of income-generating properties, and when you buy shares in that REIT, you own a portion of that real estate.

Concreit is a real estate investing app that lets you invest in a commercial real estate REIT for as little as $1. The risk is lower with this type of investment since you're investing in a diversified fund of properties rather than a single property.

If you'd rather invest in individual commercial real estate properties than funds, there are crowdfunding platforms that let you do that with lower investment minimums than buying a property yourself. Instead, you pool your money with other investors to fund commercial real estate projects, and these investments pay off as the property starts generating income. Keep in mind that investing in individual deals can have the potential to generate higher returns, but it's also higher risk than investing in a diversified portfolio of properties.

RealCrowd lets you invest in direct commercial real estate deals for as little as $5,000 and is full of educational materials to help you get started in commercial real estate. CrowdStreet lists major commercial deals like hotels and medical complexes, and you can invest in them for as little as $25,000. Both provide monthly dividends under normal circumstances, and both require you to be an accredited investor.