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Does that sound exciting and glamorous, maybe more efficient, scalable and possibly even more profitable?
Does it seem like a sign of achievement, maybe producing a feeling of moving up the real estate investing ladder?
Well, the game Monopoly taught us to buy 4 houses and then trade up to a hotel, so I wouldn’t blame you for thinking that way at all.
However, in light of today’s economic trends, I would encourage you to re-think that bit of conventional wisdom. What can I say, we’re Mavericks, we challenge conventional wisdom. 🙂
Now, this is not to say that there are no good commercial deals or you should never buy commercial. But in light of large-scale economic trends and real estate market realities I want to outline the increasing advantages to building a portfolio of residential investment properties (single family homes and 2-4 unit properties) instead of trading up to the big commercial building.
Buying a large commercial property (whether it is an apartment building, an office complex, a retail center, or whatever else) gives you a major stake in that particular market. If the market does not perform as well as expected, you are in trouble, and you have a lot of eggs in one basket, so a negative experience has a much larger overall impact on your financial situation.
Building a portfolio of residential investment properties, on the other hand, allows you to take the same amount of investment capital and diversify across many markets. This way, if one market does not perform as well as you hoped or expected, it only has a small impact on your overall portfolio, because you are well hedged and diversified.
When you own a large commercial building, you have only two choices: sell it or continue to hold it. But when you own a portfolio of residential investment property, you can choose to sell some properties while continuing to hold others—what we call a “segmented liquidation strategy”. Since real estate property cycles are very local, the optimal time to sell a property in one market will be different from the optimal time to sell a property in another market. So, you can optimize your exit strategies by having the flexibility to exit different markets at different times. You also have the flexibility to prune off any low-performing properties that are bringing down your portfolio, so you can continually keep it optimized.
If you are selling a commercial property, you will be selling it to another investor, most likely a highly experienced investor who will want to get a great deal on the property and will not be interested in paying retail price. However, if you bought your residential investment property in a community where owner occupants want to live, then you have a property that would be attractive to an end user that wants to live in it and who is more likely to pay retail price for it. There is a built-in retail market of primary homeowners looking to buy previously owned single family homes, and that makes your potential profit margin on the resale much greater.
Have you noticed a decrease in bookstores in your local area? Do you think Amazon had anything to with that? Have you noticed a decrease in Blockbuster Video locations? Do you think Netflix had anything to do with that? The answer is “of course”. There is dramatically more commerce being conducted online as products are increasingly sold over the Internet, including products like women’s shoes that many thought were imperative to be sold in physical locations so they could be tried on….until Zappos came along.
On top of the virtualization of commerce is the virtualization of the traditional office as more people are working from home or from remote work locations, and companies are cutting down on the overhead of traditional office space.
As a real estate investor, you need to consider the effect of this economic trend on commercial real estate. This is one macro-economic trend that looks like it will continue well into the future, so, as demand for physical office and retail space increasingly diminishes, is that really the type of real estate you want to be buying?
Supply and demand are always crucial factors to consider in any investment. And just as demand for office and retail locations are declining, you should consider reciprocally that human beings will always need shelter. Having a roof over your head is not something that can become virtualized.
By owning residential investment property you are providing one of the essential human needs, “shelter”, and that isn’t going out of style anytime soon.
However, when buying rental property there is still the question of apartment buildings to consider, as those provide shelter too. 5+ unit apartment buildings are classified as commercial real estate and it is fair to ask how that compares with residential (1-4 unit properties). In terms of demand trends, what has happened over the last decade is that many former homeowners have gone through the foreclosure or short sale process and have been thrust back into the rental market. Most of them will not be qualified to buy a property with a conventional mortgage for quite some time because of the damage to their credit, and so they must rent. But as former homeowners, they prefer to rent single family homes over apartments, since they were previously living in them, and this is a powerful trend that is having an impact on today’s rental landscape. We also have found that renters of single family homes tend to stay in the property for longer periods and be less transient than apartment renters, thereby reducing your expenses associated with turnover and vacancy.
As a side note, if you qualify for conventional financing, the most advantageous mortgage rates and the lowest down payments usually come with residential properties. Plus the depreciation schedule is quicker on residential too, so you can realize the tax-benefits faster as compared with commercial. Consult your CPA for more details.
If you want to position yourself to capitalize from some of the most visible macro-economic trends that are unfolding before our eyes, it make sense to strongly consider the increasing number of advantages provided by residential investment property compared with commercial, and to consider growing and diversifying your portfolio of rental homes instead of trading up to that big commercial building.
We are not legal, tax, or financial professionals. The content on this page is for informational purposes only and should not be construed as individualized advice. It is your duty to consult with your own tax, legal and financial professionals about your individual situation, applicable laws, and the suitability of any investment property for you personally. All real estate investing involves risks, which buyer assumes, and no specific returns can ever be guaranteed by anyone.
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