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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 Northern CA real estate has continued to appreciate in value. So, when they settle down, they decide to rent their first homes. And then they buy a few more houses. They know they have negative cash flow, but they are making a profit through appreciation. This is the typical story of how most real estate investors invest in residential properties. So far luck has been on his side.
As interest rates have gradually increased over the past 12-24 months while rents in the Bay Area remain very flat, the negative cash flow gap is widening. The risk of investing in residential property increases. The same old formula of investing may no longer work. At best, investors can still make money, but not as much as a percentage, since the value of real estate is already quite high. In the worst-case scenario, investors can lose money as residential real estate can remain flat or even decline in value. Is there a solution for real estate investors in Northern CA? Of course, these investors can use the same old formula in a new area that has potential for appreciation. So the key is to find that new zone. They just need to talk to someone who knows this new area. It could be Bakersfield or Sacramento or Fresno. Alternatively, investors can put money into commercial properties: retail strips, malls, medical office buildings. Let’s explore this paradigm shift to see if it makes sense for the investment.
1. Income: Commercial properties generate 50-200% more rental income compared to residential properties in the Bay Area. Also, there is no rent control for commercial properties. So landlords can charge their tenants as much as the market will allow.
2. Leases: Commercial real estate leases are generally more favorable to the landlord compared to residential leases. In addition to the base rent, tenants must also pay the landlord property taxes, insurance and all maintenance fees. These leases are called Triple Net or NNN leases. Because of this type of lease, commercial properties are better maintained than residential properties. In addition, NNN leases also remove a lot of risk to the owner, as maintenance costs are unpredictable. On the other hand, owners often postpone the maintenance of residential properties to reduce the cost. Consequently, the deferred maintenance will have a negative impact on the value of the properties.
3. Better tenants: tenants of commercial properties are financially stronger. They can be Walmart or Home Depot with billions of dollars in the bank. They are less likely to stick with you. In addition, they also guarantee the rent with their goods. If for some unforeseen reason they have to vacate the property, they continue to pay the rent or find another tenant to sublease it. They are also motivated to keep their property in good condition to attract their customers to their stores. While most residential tenants are good, some think that once they pay rent they have a license to trash your property and then disappear into thin air with no forwarding address.
4. Long-term lease: commercial tenants are less likely to move. They often sign leases of 5 to 10 years. Tenants like Walgreens and Walmart sometimes sign 20- to 50-year leases. In contrast, residential rentals are short-term. They could move to a new place a mile away for a $25 rent reduction! It is a fact that the turnover rate of residential tenants is very high compared to commercial tenants. As a homeowner, this causes you more unnecessary headaches and migraine stress.
5. Management: It’s much easier to manage a mall of 10 tenants than 10 individual homes in 10 different locations. In fact, if you have 10 rental properties, your tenants have probably worn you out and we’re exhausted. They often move in the summer just as you want to go on vacation. Yes, it is a fact that residential properties are very management intensive due to the high turnover rate. If you have to hire a property manager, it also costs more as a percentage of the rent to manage residential properties. Plus, it’s probably a full-time job just to manage those 10 property managers!
6. Income Statement: it is much easier to track income tax records for a 10-unit shopping center than for 10 separate residential rentals in multiple states. You only need to have one file for the mall while you will need 10 folders for 10 residential rentals. The task becomes more difficult since the IRS requires you to keep records for several years. Your out-of-state income tax return is also thinner for a 10-unit shopping center than for 10 residential rentals.
7. Tax cancellations: Commercial properties offer the same tax write-offs, 1031 exchange as residential rentals.
8. Impact of Credit Scores: most people don’t know that once they have about 10 home mortgages, their credit score will start to drop. The credit bureau argues that the more money you borrow, the higher the credit risk, and the threshold appears to be between 9 and 10 mortgages. On the other hand, commercial mortgages do not have any negative impact on your credit scores since these mortgages are not reported to all 3 credit bureaus.
9. Pride of ownership: most commercial properties are referred to by name rather than address, eg Lion Plaza or Valley Fair Shopping Center. They could be trophy properties that offer tremendous pride of ownership. You get a lot of respect when you tell people you have a certain mall they know.
10. Size of the investment: Commercial properties often require a substantial amount of money, so they are not meant for someone with a modest amount of money.
So if you want to work hard for your money or bet on appreciation, invest in residential. If you want to work smart, look for commercial properties. Investing in commercial real estate is a more prudent way to invest in real estate if you have more capital for a down payment. You have a strong positive cash flow every month, so you don’t need 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 part of the elite group of real estate investors. You’re probably wondering where you should go from here if you want to explore this possibility further. These topics will be covered in the next 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 these articles, you can sign up for a free seminar on Commercial Real Estate Investing at Transmercial. The San Jose Real Estate Investor Club (phone number 408-264-3198) occasionally offers a similar seminar for a small fee.
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