Any property, whether designated for commercial or residential use, holds potential as an investment. Typically, commercial properties, such as retail spaces or industrial buildings, offer greater financial returns compared to residential options like rental apartments or single-family homes. However, this higher reward often comes with increased risks. Understanding the comprehensive advantages and disadvantages of investing in commercial properties is crucial for making an informed decision that aligns with your financial goals.
Defining “Commercial Property”
The term “commercial property” encompasses a diverse range of real estate types, including:
- Retail buildings: Such as standalone stores or multi-unit strip malls.
- Office buildings: Ranging from small professional suites to large corporate complexes.
- Warehouses: Facilities primarily used for storage and distribution.
- Industrial buildings: Properties suited for manufacturing, production, or heavy equipment.
- Apartment buildings: While residential in nature for tenants, these are considered commercial investments for the owner.
- “Mixed-use” buildings: Properties that combine various functions, like ground-floor retail with office space and residential apartments above.
Each of these property types has unique management nuances. For a general understanding, let’s explore the pros and cons through the lens of investing in a single-story commercial retail building, such as a community strip mall.
Advantages of Investing in Commercial Property
Here are several compelling reasons to choose commercial real estate over residential property for investment:
- Significant Income Potential: The primary draw of commercial rentals over residential is their earning capacity. Commercial properties typically yield an annual return on the purchase price between 6% and 12%. This range can fluctuate based on the specific location, current economic climate, and external factors like pandemics. This is a considerably higher range than what is usually seen for single-family residential properties, which at best might offer 1% to 4%.
- Professional Relationships: Small business owners generally take pride in their ventures and are motivated to protect their livelihood. Furthermore, owners of commercial properties are often legal entities, like LLCs, operating the property as a business. This fosters a professional, business-to-business relationship between landlord and tenant, which tends to result in more courteous and professional interactions.
- Public Scrutiny of the Property: Retail tenants have a vested interest in maintaining their storefront and interior space. Neglecting their appearance directly impacts their business. This alignment of interests between commercial tenants and property owners helps the owner ensure the property’s quality is maintained and improved, ultimately safeguarding the investment’s value.
- Limited Hours of Operation: Businesses generally operate during specific hours and close at night. This means your work as a landlord largely aligns with their business hours. Barring emergencies like break-ins or fire alarms, you’re less likely to receive disruptive late-night calls for repairs or lost keys. Commercial properties also often utilize alarm monitoring services, ensuring that any after-hours incidents are handled by appropriate authorities.
- More Objective Price Evaluations: Valuing commercial property is often more straightforward than residential. Investors can request the current owner’s income statement to determine a fair price based on prevailing market rates. Knowledgeable brokers typically price commercial properties to ensure an investor can achieve the area’s typical capitalization rate for that specific commercial property type (retail, office, industrial, etc.). Residential property valuations, conversely, can be more susceptible to emotional pricing.
- Triple Net Leases: While variations exist, the fundamental concept of a triple net lease (NNN) means the property owner is largely absolved of property expenses that would typically fall to a residential landlord. The lessee directly covers all property expenses, including real estate taxes, insurance, and maintenance. Your only major expense might be the mortgage. Large corporations such as Walgreens, CVS, and Starbucks frequently enter into these types of leases, as they prefer to manage property upkeep to align with their brand standards. This translates to a significantly lower-maintenance income stream for the investor. While strip malls may have a mix of lease types and smaller businesses might not always agree to NNN leases, these arrangements are highly advantageous and are generally unavailable in residential property investments.
- Greater Flexibility in Lease Terms: Commercial leases are governed by fewer consumer protection laws compared to residential real estate, which is subject to numerous state-specific regulations concerning security deposits, termination rules, and more. This allows for greater flexibility in negotiating lease terms beneficial to the property owner.
Disadvantages of Investing in Commercial Property
Despite the many advantages, investing in commercial real estate also comes with notable downsides:
- Significant Time Commitment: Owning a commercial retail building with multiple tenants, even just a few, demands more active management than a residential investment. To maximize your return, you cannot be an absentee landlord. Commercial property management often involves dealing with multiple complex leases, annual Common Area Maintenance (CAM) adjustments (costs tenants are responsible for), more frequent and varied maintenance issues, and public safety concerns. In essence, there’s a greater managerial burden, and just as tenants are under public scrutiny, so too is the property owner.
- Requirement for Professional Help: Unless you are a licensed professional equipped to handle various maintenance issues yourself, you will almost certainly need to hire outside help for emergencies and repairs at a commercial property. This adds to your operating expenses, and it’s crucial to factor in property management costs when evaluating the investment. Property management companies typically charge 5-10% of rent revenues for their services, which often include lease administration. You must decide whether to manage leasing and tenant relationships yourself or outsource these responsibilities.
- Larger Initial Investment: Acquiring a commercial property usually requires substantially more upfront capital than purchasing a residential rental in the same area, making it harder to enter the market. Moreover, once acquired, commercial properties can demand significant capital expenditures. For instance, a property might operate smoothly for months before suddenly requiring a $10,000 bill for roofing repairs or a new furnace. With more public traffic, there are more facilities to maintain, leading to potentially higher costs. The hope is that the increased revenue from commercial property will sufficiently outweigh these higher costs compared to residential investments.
- Increased Risks: Commercial properties, due to their public nature, experience significantly more visitor traffic daily. This inherently increases the likelihood of incidents where individuals could be injured or property could be damaged. Examples include vehicles hitting pedestrians in parking lots, slips and falls on icy surfaces during winter, or vandalism like graffiti. While such incidents can occur anywhere, the probability escalates with commercial investments. If you are risk-averse, residential properties might be a more suitable investment.