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Residential vs. Commercial Real Estate Investment Comparison

This is a column by our resident real estate expert Rachelle.

I actually live and work in the Toronto area, in Ontario and this post is about different kinds of properties you can invest in and the benefits and pitfalls of developing a portfolio of properties that is not residential.

Law

Residential Property

The law in Ontario for residential property is not kind to investors. Landlords are not protected and a lot of waiting is required before being able to get non-paying tenants out. Twice I have seen cases of non-payment that took over 9 months to resolve. Even if you are proactive, you are looking at 3 or 4 months before the process is complete.

Commercial Property

Commercial property law can be very complex and the leases can be intimidating. The good news is that unlike residential leases, these leases are subject to contract law. This means that the lease is whatever you and the tenant agree to and it is enforceable. Absolutely everything can be stipulated in the lease and is binding on both parties. I suggest a lawyer help you with this at first until you get the hang of it.

Commercial leases can also be simple. One thing all commercial leases have in common is that they really protect the landlord. Leases are renegotiated, not automatically renewed and there is no limit to the rent increases except what you contracted to and what the tenant can pay or the market will bear.

Dealing with non-payment of rent is easy. Here I am quoting from the Commercial Tenancies Act (link).

Rights of re-entry

Re-entry on non-payment of rent

18. (1) Every demise, whether by parol or in writing and whenever made, unless it is otherwise agreed, shall be deemed to include an agreement that if the rent reserved, or any part thereof, remains unpaid for fifteen days after any of the days on which it ought to have been paid, although no formal demand thereof has been made, it is lawful for the landlord at any time thereafter to re-enter into and upon the demised premises or any part thereof in the name of the whole and to have again, repossess and enjoy the same as of the landlord’s former estate. R.S.O. 1990, c. L.7, s. 18 (1).

Commercial leases are beautiful for the landlords they protect. You can’t really appreciate this until you have had a residential tenant delay an eviction forever while you pay the mortgage and all the expenses while they live a free life. And possibly wreck your property.

Ease of Entry & Financing

Residential Property

Currently 20% down is required for a down payment. In the past financing has been relatively easy but with the new CMHC rules it is becoming more difficult. CMHC is requiring that only 50% of the rental income of your properties be considered when calculating your income. This becomes problematic when you have multiple properties.

Commercial Property

Before the new CMHC rules came into play April 19th this was really the biggest factor. Commercial properties generally have higher entry requirements. Down payments are 30 to 35%. Financing is never CMHC approved so you need good credit and be willing to put personal guarantees on the building. Mortgage rates are higher. For the beginner there are tons of little industrial or office or retail condominiums available. You can also buy a mixed-use building that has a few apartments on the second floor and retail or restaurant below.

Familiarity

Residential Property

A second benefit of residential rentals is people’s familiarity with that kind of real estate. Rare is the person who has never rented or lived in a house. People are well acquainted with the processes involved in this business. They are also somewhat knowledgeable about the usual building systems of a house. Plumbing, electrical, furnaces and air conditioners are all somewhat understood by most people.

Commercial Property

Depending on what you buy there may be lots of building elements that you are not familiar with. The other day I was checking out an industrial building full of commercial laundry equipment. One machine was the size of two pick up trucks side by side. I had never seen anything like it. Basically units you buy can be outfitted for anything from a restaurant, an office or any other type of business. There is usually no presentation involved so you have to look past the dust and debris.

Vacancy Risk

Residential Property

A third benefit of residential is the considerable number of potential applicants. Vacancy is currently low and a property with a decent price in decent condition is not likely to stay empty for long.

Commercial Property

This is the tricky part. These properties can be more difficult to rent. You must also evaluate the feasibility of that business at that location. I once rented a space that had been vacant for five years. The location was a pizza store but it was the stupidest location ever for pizza. Have you ever seen a pizza store on a quiet one-way street? It was also extremely disgusting with years of cooking grease on the walls. Presentation counts!!! I sold all the pizza equipment for a song, we power washed, painted and it rented in a month.

Generally these spaces stay empty longer and are more difficult to rent. Be proactive and spend some money on advertising. Consider changing the use. Clean up and present the space in good condition.

Once the space is rented though tenants will stay for a long time. It’s not like packing up a cube van for a residential tenant. Commercial tenants have clients, business cards, ads in the Yellow pages and all kinds of expensive commercial equipment. Moving is very expensive for them so you can usually look forward to long leases. Five or ten year leases with options to renew are normal. Certain businesses are more prone to failure than others so choose accordingly.

Purchasing

Residential Property

The biggest problem with new investors is that in a tight market like Toronto is that they are very vulnerable. There’s a ton of people who just don’t care about you who are willing to separate you from your dough. I would say that about 90% of the offerings in the Toronto market would not qualify for my definition of investment.

AN INVESTMENT PROPERTY MUST PAY YOU TO OWN IT.

This is not a pretty house you own and rent out in hopes of the land appreciating. That is speculation and I can assure you that one day, property value will go down. If you buy for cash flow with the proper safety margins in place, it really doesn’t matter because every month that building is being paid off and, it’s paying you to own it. That is investment.

Because there is so much crap on the residential market waiting for a sucker, the smaller entry-level properties that are decent with potential go very quickly and there’s a lot of competition.

Commercial Property

Not sexy comes to mind when talking about commercial property. I can assure you there’s a lot less competition for these properties. These properties are sold in a much different way. You get things like income statements and expense reports. In short it’s about the money. I find the “appeal to emotion” sales strategy irritating as hell when I’m looking at income property. I’m never going to live there so show me the numbers and stop wasting my time. You’ll find a lot more people who know how to do this around commercial property purchases.

Passing on costs

Residential Property

Another risk involved in smaller residential property is the difficulty of passing on costs. Rent increases are limited by legislation. Consider that Hydro costs alone will increase a full 25% this year. You can see how this can quickly become a problem. If your investment property is a condo you may well get very significant increases in maintenance fees. It’s easy to see how the small landlord can quickly end up subsidizing his tenants housing by several hundreds of dollars every single month. OUCH !!!

Commercial Property

Most leases for commercial properties are Net Net Net. This means that the tenant is responsible for Taxes, Maintenance and Insurance for the property. Utilities are paid by the tenant; you never know what the space will be used for. Some businesses use lots of hydro, gas or water. In some shopping centers the landlord even gets a percentage of gross sales for the business.

You can be fully insulated against increases in your costs.

So investors I challenge you to stretch a little and really consider commercial type properties. When you’re in business there are always risks but in my opinion the legal risks of being a residential landlord are considerable compared to commercial property. The ease of entry and familiarity of residential investments is a not sufficient reason to invest in that market. For the new investor you can buy mixed-use properties and get the best of both worlds and diversification to boot. Remember; fall in love with the numbers not the properties.

About the Author: Rachelle specializes in renting property on behalf of landlords. She also works with investors to find good investments in Toronto and surrounding areas. Her passion is bringing multi res properties back from the brink and maximizing profitability.

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About the author: This is a guest post. You can read more about the author in the biography above.

{ 14 comments… add one }
  • FT FrugalTrader May 26, 2010, 10:51 am

    Thanks for the post Rachelle. I do like the advantages of commercial real estate as it falls under contract law instead of tenant law.

    Do you do much work with commercial real estate clients?

  • willfly1 May 26, 2010, 11:56 am

    Very informative writeup. I have experience in residential RE, so can corroborate those points.

  • Rachelle May 26, 2010, 12:03 pm

    Yes I do work with commercial real estate clients and quite frankly I’d love to do more. The bigger residential landlords all fall into the commercial category. They all love the numbers as much as I do.

    I have managed mixed use properties as well.

    Truly though I am seeing a lot of opportunity in the industrial market these days. This is one of the most overlooked asset classes and I personally think there is a lot of money to be made buying up larger spaces and renting them as smaller spaces. I rented in an industrial plaza before and got to see first hand how that worked for the landlord. He had very low turnover and units rented fairly quickly. You wouldn’t believe the amount of uses these units are put to. We had a rich guy building a model car in one, samosa making, roofers, sign companies, furniture refinishing and even one lady who made those parisienne (small round peeled) potatoes.

    I believe that in real estate as in the stock market you need to head away from the pack to make the best returns. If people aren’t telling you how crazy you are, you’re doing something wrong.

    Further because these properties are pretty illiquid, great deals are there for those who make offers.

  • Andrew F May 26, 2010, 1:11 pm

    What services do you provide, Rachelle? Do you help investors identify properties, and do you help with management? I have always been leery of residential as an investment (I’d rather leave that to a REIT!) but I like the idea of commercial real estate and have been involved in joint ventures with a friend who has now sadly passed away, and the investment company was folded.

    What can one expect to pay for these kinds of services?

  • Financial Uproar May 26, 2010, 1:57 pm

    The more I read these guest posts by Rachelle, the more I’m glad that I have a great property manager. In fact, without his services I probably would have gotten frustrated and sold my rental property a long time ago.

    For the average Joe, REITs are a much better way to play the real estate market. If you share my view of Canada having overvalued real estate you probably wouldn’t want to buy now though.

  • Rachelle May 26, 2010, 3:13 pm

    @ Andrew

    There is no easy answer to your question.

    The typical joint venture deal is 50/50. You put up all the money and closing costs and the mortgage. Capital appreciation and net income is split 50/50.

    The other option is a Limited Partnership company which is better suited to larger deals with more partners (up to 12)

    For me joint ventures are the next level. In the past I have been hired to manage these derelict properties back to cash flow happiness. Because I am new to the game of joint ventures I am perfectly happy to do a 25/75 split on any joint ventures, simply put, there is a lot I don’t know… yet.

    I really like the idea of joint ventures, the main thing being that if the joint venture partner doesn’t perform, they don’t make any money. I like deals where the people working together are perfectly aligned.

    This is not always true in conventional property management. There is basically a continual power struggle between the owner, who wants more services, and the property manager who will make more by providing less service.

    The joint venture way is about performance and for me those kinds of deals are the best kind.

    For those who want to consult on buying property I do that too. You can trust me to tell you what I really think, even if it’s not what you want to hear. It’s a lot of work to find something that will cash flow in this market. You have to kiss a lot of frogs before you find a prince :)

  • Ms Save Money May 26, 2010, 5:25 pm

    I had NO idea that it could take that long for the processes of kicking out a tenant. It must be hard because you’d not only have to deal with the tenant, but also go through so many loops just to get the paperwork done. However, I do see the points you address and it has clarified for me about each of these types of real estate investments.

  • Rachelle May 26, 2010, 6:00 pm

    Worst case scenario it can take a very long time. A long time with no money to pay the mortgages, taxes and expenses.

    I have been to the Supreme Court of Ontario with a tenant who appealed the Landlord & Tenant Board ruling. She had no basis for appealing whatsoever. She got Legal Aid and didn’t show up claiming she was ill the first time (she got a friend to bring a Dr’s note) the second time was right after September 11th, she sent a friend to tell the court she couldn’t appear due to the fact that she was ministering to the victims of September 11th. That’s when the case was finally dismissed. Every time our lawyer appeared it cost us $1400.

    The previous property manager rented to her. Basically the owners kept him on for an extra month for the turnover and to “train” me. During this time he rented to this lady quite deliberately. I never once met him. She had a drug problem and was a prostitute. Part of my job was to call her and try to get her to pay rent. Of course she never answered but the girls in the office and I used to listen to her creative voice messages and laugh our heads off. Things like “Rrrrrr, this is Miss Kitty, I want to talk to you now, Roaooow. Leave your number, Tiger.

    So it’s very advisable to have a large reserve fund for just this kind of eventuality. People have lost their rental properties because of this kind of tenant.

  • The Passive Income Earner May 26, 2010, 7:35 pm

    Great post! This is very informative. I had started researching multi-units to identify the cost of entry but I may look at the commercial opportunities too.

  • Financial Cents May 26, 2010, 9:22 pm

    Great, detailed post Rachelle. Keep your updates and experiences about real estate coming.

  • TK May 27, 2010, 12:15 am

    Hi Rachelle, I’ve been enjoying your articles on MDJ. Very informative. Do you have a website or can you post your contact information?

    Thanks!

  • Rachelle May 28, 2010, 9:43 am

    @TK

    I do have a website I am working on…. in the meantime the best way to get a hold of me is by emailing FT and he will pass on my email.

    You can also register in the Canadian Money Forum and I am always posting there and answering questions.

    My handle there and elsewhere on the web is Berubeland.

  • PC August 13, 2011, 5:11 pm

    Hi There,

    At what point does a rental property become commercial. Say a triplex is residential. How many units can I have before it is recognized as commercial?
    4? 5?

    Thanks

  • Sabrina September 27, 2016, 12:44 am

    Is the down payment also 30-35% for a mixed use commercial/residential building or just commercial? Thanks!

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