June 23, 2024

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The Pros And Cons Of Investing In Different Types Of Real Estate

The Pros And Cons Of Investing In Different Types Of Real Estate

Commercial Real Estate Investor & Broker – Elite Commercial Real Estate.

There are many benefits to investing in real estate that other investment strategies may not offer—for example, utilizing leverage to build wealth or depreciation and cost segregation write-offs to reduce your taxable income. In addition, historically, real estate investments are less prone to major market swings.

However, after you’ve made the decision to invest in real estate, you’ll need to figure out which types of investments are best suited for you. There are many differences between commercial and residential properties, and within those, there are different types of assets, all of which have their own benefits and challenges.

Whether you are new to investing in real estate or a seasoned investor considering how to diversify or grow your portfolio, it is important to understand the differences and types of properties available. I’ve invested in both commercial and residential, and while I prefer commercial, there are times when a residential property still makes sense due to its lower capital requirements and countless other factors.

Types Of Commercial Real Estate

When considering a commercial real estate investment, you must first consider which type of asset you are interested in: retail, office industrial or 5-plus unit multifamily properties. Within all these asset types, there are different classes of properties: A, B or C. Then, with retail, office and industrial assets, there are also multitenant properties versus single tenant properties. You’ll also have to consider if you prefer a stabilized or value-add property. Each asset type has its unique benefits and challenges as well as varying cap rates depending on the perceived risk and LTV ratios required by commercial lenders. There are also countless macroeconomic factors that are unique to local markets, which affect supply and demand.

Pros And Cons Of Commercial Real Estate

Pro: One of the key benefits of investing in commercial real estate for entrepreneurs and investors is that the debt service coverage ratio (DSCR) is based on the property’s income and the borrower’s net worth, as opposed to an individual’s earned income.

Con: The challenge is the higher down payment requirement. While some asset types may qualify for 25% down, most require 30%-40% down.

Pro: Favorable and longer lease terms of five, seven, 10 or 15 years are common when it comes to office, retail and industrial properties, with three being the shortest and less common. In addition, there are usually escalations to adjust for inflation. Also, many leases are NNN, which allows investors to pass through actual incurred operating expenses so the increased expense risk falls on the tenant’s side, as opposed to the landlord’s. Lastly, tenants are typically responsible for most maintenance and repairs within their space.

Con: The challenge is the cost and time it takes to lease-up commercial properties. In addition to greater vacancy risk and time to find tenants, you must also consider leasing costs. This may include tenant concessions such as free rent, tenant improvement allowances and leasing commissions. On top of all that, capital improvements to the property may also be required to make the property more appealing to potential tenants.

Pro: Another major benefit is the exponential growth potential when leases expire or when it comes to value-add properties since valuation is based on cash flow and creditworthiness of tenants, as opposed to just comps. Essentially, if you acquire an asset with vacancies and lease-up those spaces, you could potentially double or triple the value of your asset based on the creditworthiness of tenants and the property’s increased income.

Con: One of the biggest challenges is the working capital required. If repairs come up, they can be significant, so investors will want to be sure they have sufficient capital reserves to avoid deferred maintenance, which can lead to bigger issues. In addition, if tenant improvement allowances are required to lease out a space, landlords will want to make sure they are able to provide this to secure a good tenant.

Types Of Residential

When considering a residential real estate investment, you should also consider which type of asset you are interested in. Residential real estate investment properties include single-family homes, condos, townhouses, duplexes, fourplexes or even co-ops in certain cities. Then, you’ll also want to consider if there is a homeowner’s association and how much it costs, as those monthly fees cut into your cash flow. In addition, you will need to consider if you would prefer new construction or a resale.

Pros And Cons Of Residential Real Estate

Pro: There are lower capital requirements. Residential investment properties only require 20%-25% down. In addition, the price points for a cash-flowing property are also significantly lower.

Con: Typically, you need to choose between appreciation or cash flow when it comes to residential properties. The investments with greater appreciation potential typically don’t cash flow well, if at all. On the other hand, those that do cash flow well typically don’t have great appreciation potential.

Pro: There is less vacancy risk. The time to lease up a residential property is usually significantly less than the time it takes to lease up a commercial space, with few exceptions.

Con: There is less cash flow and upside potential. Cash flow on residential properties is usually limited and can easily break even or go in the red if a major repair is required. Upside potential is also limited, as it is more dependent on comps and market conditions.

Pro: There are lower capital reserves and maintenance costs. You can mitigate your repair and maintenance risk by acquiring a home warranty policy or simply acquiring a new home with a builder’s warranty.

Con: Landlords are typically responsible for all the maintenance and repairs on residential properties, unlike commercial, where tenants are responsible for their own space or expenses are passed through.

These pros and cons are just the tip of the iceberg when it comes to evaluating your real estate investing strategy. In all decisions like these, it is usually in your best interest to consult a specialist. Even as a seasoned broker and investor myself, I seek out the help of an expert when evaluating a new market.

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