When I first got started I was a little confused about what the difference was between commercial and residential real estate. Brokers that were considered “commercial” were selling fully residential apartment buildings with no retail or office involved.
The truth is, there’s no hard and fast rules behind these definitions, so don’t feel confused like I did when I just started out. Office, retail, industrial, and flex buildings are all firmly within the commercial realm. Larger apartment buildings are typically also treated as commercial real estate. This is because the buyers involved with larger apartment buildings are savvy investors who have different requirements and considerations when looking at a real estate transaction. They treat their purchase as a business rather than their own residence.
The grey area is in smaller multi-family transactions that may be sold by agents that primarily specialize in residential real estate. Here are a few differences and considerations when you’re considering residential or commercial real estate investments:
1. Single Family Rentals:
Different real estate markets have different characteristics in terms of the renter population. Some markets may have smaller one bedroom units in mid-sized multi-family buildings in high demand. Other markets may have a lower proportion of renters in general and the majority of residents are homeowners. A variety of factors, including the historical trends in the area as well as the state of the local economy can cause the renter profile to differ. In certain areas of the country single family rentals are in high demand. If you happen to live in those areas, getting your start in single family rentals is a great path.
I would advise that you eventually move towards multi-family investment because there is additional risk involved when each property you own has only a single tenant. I still think it is a good path to start with because it is very difficult to build the credibility to purchase those larger buildings with your lenders and investors unless you have experience as an operator and have an existing rental portfolio. Single family rentals will typically be sold by “residential” agents on the open market. Ideally, you find an agent that specializes in smaller individual transactions that understands the needs of an investor.
2. Multi-Family Residential:
The multi-family residential asset class is the largest grey area when we’re discussing commercial vs. residential real estate. I would typically say that once you’re purchasing buildings above 20 units in size, you’re going to be dealing with commercial brokers.
This can differ greatly based on the price per unit in your market, so there is no true specific unit count. An easy way to understand is that the more expensive a real estate transaction, the more likely you will be dealing with sophisticated brokers that treat their offering as a business transaction.
A good broker selling larger residential assets will give you important information that will allow you to judge the profitability of the opportunity. Look out for the cap rate, price per unit, price per square foot, gross scheduled income, area vacancy rate, and operating expenses, at a minimum, when evaluating the initial offering memorandums prepared by a commercial broker for these types of deals.
3. Office, Retail, Industrial, and Flex Space:
These all fall squarely under the commercial umbrella and will be sold by commercial brokers. Expect to deal with savvier but more reasonable sellers and brokers. A good commercial broker won’t try to put lipstick on a pig and manipulate the numbers the way a more inexperienced realtor who primarily deals in selling to end-user homebuyers might.
You will see similar analysis metrics as you will with larger multi-family real estate transactions. The main difference is the types of leases in place. Residential leases will ideally have an annual term, with the landlord responsible for the majority of the property upkeep.
With pure commercial properties, you will be dealing with triple net or double net leases and much longer terms. For example, you could purchase a retail asset with an existing tenant in place that has a 15 year triple net lease. This would mean they pay for all or most of the associated expenses, including even insurance and taxes.
4. Commercial Leases:
Things to keep in mind here will be that rental rates are calculated on a per square foot basis. The per square foot figure that is provided when these units are listed can be based on an annual or monthly basis, depending on what market you are operating in. This is just based on local tradition and has no real reason behind it. If you are operating in a market where the price per square foot rental rate is calculated by the month, if the listing for a commercial lease stated $2/ft and the unit was 1000 square feet, the monthly rate would be $2000. As described above, the lease terms can also vary widely, with lengths of 15 years or more.
5. Condominium vs. Apartment Building Development:
Mid-sized developers building in dense urban areas often get their start, as we did, in multi-family development with the intention of converting the building into condominiums and selling each unit to an end-user at the project’s completion.
Once you start scaling up to building 50+ unit multi-family complexes, it becomes more difficult to sell each individual unit as a condominium. You could saturate the market with more units than it can bear at once. The risk involved with having to sell larger and larger amounts of units as condominiums and the work associated with doing so becomes infeasible.
That is why larger multi-family developers intend from the beginning to sell to long-term institutional rental investors. Before breaking ground, the projected rents, expenses, cap rate, and the like will have been properly calculated. Investors will be involved on the equity side of the transaction and your construction budget will be scrutinized in order to determine if the projected cash flow post-stabilization will be able to support the debt and equity obligations. As of the writing of this article, you’ll typically need a 6% or greater return on cost and a 20% or greater return on TDC in order to qualify for funding.