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Should You Invest in Residential Or Commercial Properties?
Most people in Northern CA started investing in real estate by buying their own homes. And most have made money as real estate values in Northern CA have increased. So when they move up, they decide to rent out their first home. And then they buy some more houses. They know they have negative cash flow but the appreciation makes a profit. This is a typical story of how most real estate investors invest in residential properties. Luck was on their side so far.
While interest rates have gradually risen over the past 12-24 months, rents in the Bay Area have remained fairly flat, widening the negative cash flow gap. The risk of investing in residential properties is increasing. The same old investment formula will no longer work. In the best case, the investor can still make money but not much in percentage terms because the value of the real estate is already very high. In the worst-case scenario, residential real estate may remain flat or even decline in value, causing investors to lose money. Is there a solution for real estate investors in Northern CA? Of course, these investors can use the same old formula in new areas that have potential for appreciation. So it is important to explore this new area. They just want to talk to someone who knows this new field. It could be Bakersfield or Sacramento or Fresno. Alternatively, investors can put money into commercial properties: retail strips, shopping centers, medical office buildings. Let’s explore this paradigm shift to see if it makes investment sense.
1. Income: Commercial properties generate 50 to 200% more rental income than residential properties in the Bay Area. Additionally, there is no rent control for commercial properties. So landlords can charge your tenants as much as the market allows.
2. Stripes: Commercial real estate leases are generally more favorable to the landlord than residential leases. In addition to the base rent, tenants must pay the landlord for all property taxes, insurance and maintenance costs. These leases are called triple net or NNN leases. With this type of lease, commercial properties are better maintained than residential properties. In addition, NNN leases also take a lot of risk from the landlord because maintenance costs are unpredictable. On the other hand, homeowners postpone maintenance of residential properties to reduce costs. As a result, deferred maintenance will negatively impact the value of properties.
3. Better tenants: Tenants for commercial properties are financially strong. It could be Walmart or Home Depot with billions of dollars in the bank. They are less likely to nickel and dime you. In addition, they also guarantee the lease with their property. If for some unforeseen reason they have to vacate the property, they continue to pay the rent or find another tenant to rent it to. They tend to keep your property in good condition to attract their customers to their store. While the majority of residential tenants are good, some think that once they pay rent they have a license to litter your property and then disappear into thin air with no forwarding address!
4. Long Term Lease: Commercial tenants are less likely to move. They usually sign a 5-10 year lease. Tenants like Walgreens and Walmart sometimes sign 20-50 year leases. In contrast, residential leases are short-term. They can move to a new location a mile away to get a $25 discount on rent! It is a fact that the turn over rate of residential tenants is much higher than that of commercial tenants. As a landlord, this gives you more unnecessary migraine headaches and stress.
5. Management: A 10-tenant shopping center is much easier to manage than 10 individual homes in 10 different locations. In fact, if you have 10 residential rentals, your tenants have probably harassed you and we’re tired. They usually come out in the summer around the time you want to go on vacation. Yes, it is a fact that management of residential properties is very intensive due to high turn over rate. If you need to hire a property manager, residential property management costs more as a percentage of rent. Besides, managing these 10 asset managers is probably a full-time job!
6. Income Tax Refund: In many states it is much easier to keep track of records for income tax purposes for a 10-unit shopping center than for 10 separate residential rentals. You need to have only one file for a shopping center while you need 10 folders for 10 residential rentals. This task becomes more challenging because the IRS requires you to keep records for several years. Your out-of-state income tax return is thinner than 10 residential rentals for a 10-unit shopping center.
7. Tax write-off: Commercial properties offer the same tax write-off as residential rental 1031 exchanges.
8. Credit Score Impact: Many people don’t realize that once they have about 10 residential mortgages, their credit score begins to decline. Credit bureaus reason that the more money you borrow, the higher the credit risk, and 9-10 appears to be the mortgage threshold. On the other hand, commercial mortgages have no negative impact on your credit score because these mortgages are not reported to the 3 credit bureaus.
9. Pride of Ownership: Many commercial properties are referred to by name and not by address, for example Lion Plaza, or Valley Fair Shopping Center. They can be trophy properties that provide immense pride of ownership. You gain a lot of respect when you tell people that you know a particular shopping center that you own.
10. Size of Investment: Commercial property often requires large sums of money so it is not modest for an individual.
So if you want to work hard for your money or bet on appreciation, invest in residential sector. If you want to work smarter, go after professional properties. Commercial real estate investing is a more prudent way to invest in real estate if you have more equity for a down payment. You have strong positive cash flow each month so you don’t have to rely on appreciation alone to make money. So if you haven’t invested in commercial real estate, now you know why you’re not among the elite group of real estate investors. If you want to explore this possibility further, you may be wondering where to go from here. These topics will be discussed in the coming issues
o Which commercial property should you invest in?
o Where should you invest in commercial real estate?
o How to pick and choose a good commercial property
o What you should know before hiring a property management company
If you can’t wait for those articles, you can sign up for a free seminar on commercial real estate investing at Transcommercial. The San Jose Real Estate Investors Club (phone number 408-264-3198) occasionally offers similar seminars for a small fee.
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