Investment experts Michael Hills and Whitney Nicely share what newbie investors need to know about the upsides and downsides of investing in residential or commercial real estate.
Real estate investing can be a lucrative venture, with unprecedented opportunity to generate passive income and build generational wealth. However, great rewards come with great responsibilities and risks that can easily lead to financial ruin.
Real estate investing experts Whitney Nicely of She Buys It and Michael Hills of Atlas Real Estate sat down with Inman’s Property Portfolio to discuss the various real estate investing options and what investors need to think about before starting or expanding their portfolios.
Here’s what they had to say:
What is the difference between residential and commercial real estate?
In the investing world, residential real estate is limited to single-family homes and properties that are four units or less. When it comes to commercial real estate, there are more property options that include retail, office space, land, and warehouse and industrial. There’s also residential commercial that includes multi-family properties that are five units or more.
What’s the financing process for these properties? Does one type of investing offer better financing opportunities than the other?
For Atlas Real Estate VP of Investment Brokerage Michael Hills, residential real estate offers better financing, especially for beginning investors who haven’t built a consistent and robust cash flow.
“When you say you’re buying a residential investment, the first thing [lenders] will ask is if it’s a one unit, two unit, three unit, four unit, or something over four units,” Hills said. “The major difference other than the size, is when you buy four units and under, you can still get residential financing.”
“When you buy something five units and up, it’s commercial financing and there are some major pros to getting residential financing and some major cons to getting commercial financing,” Hills added.
Hills owns three four-unit properties, one six-unit property, and one 23-unit property. For his four-unit properties, Hill was able to get a 30-year, fixed-rate amortized loan where he’s able to pay the same monthly mortgage until the property is paid off.
However, his six-unit and 23-unit properties required a commercial loan, which Hill said is typically a 25-year, adjustable-rate amortized loan with a balloon payment after 10 years. At that 10-year mark, investors can refinance, sell the property or pay it off — something that can be easy or hard to do based on the cash flow an investor has managed to generate.
Meanwhile, Nicely suggests investors skip loans altogether and pursue seller financing that allows the buyer to put zero or little down on a property. With this method, the seller deeds the property to the investor, and the investor pays back the purchase price over time.
According to Nicely, who has 19 apartment complexes and 15 lease-option homes in her portfolio, seller financing is an effective method that allows investors to build a strong cash flow that can be used to quickly pay off properties without reaching into a personal account.
“You don’t have to give anybody your credit, you don’t have to go to the bank, you don’t have to offer 20 percent down,” she explained. “You can buy properties with no money down, and let the owner carry the note for you for five, 10 or 30 years. That’s the best way to get into anything because you don’t have your life savings at risk.”
How do you find and vet tenants for residential or commercial properties? Which option has higher demand?
Both experts agreed — it’s much easier to find tenants for residential and residential commercial real estate.
“Everybody needs a place to sleep and that [need] is not going anywhere,” Hills said.
When it comes to single-family and multi-family residential real estate, Nicely said attracting tenants is much like attracting buyers to a listing — a property must have the right look, feel, location and proximity to amenities and family. On the other hand, attracting commercial tenants is more about focusing on the functionality of a space rather than the aesthetics or surrounding amenities.
“They just want to know the traffic count and want to make sure it’s close to the interstate,” Nicely said of her warehouse and trucking clients.
Although the marketing tactics differ, Hills said the vetting process for residential and commercial tenants is similar. Although he uses a property management company for this process, Hills suggests investors only choose tenants with strong financials, which includes strong income and job stability.
“Whether its a business moving into your commercial space or a family moving into a residential space, you need to look for strong financials. You know, people who can pay the rent,” he said. “Strong income where if something happens next week where their car breaks down or they need to hire new people, they have enough income to still make the rent.”
“When it comes to [residential] tenants, we’ve found the number one factor is the length of time at their job,” he added. “If they’ve been at their job a really long time, they’re most likely consistent and stable, therefore paying rent will be consistent.”
For commercial tenants, Hills looks at their business finances and taxes for a track record of strong cash flow and responsible financial management. He also asks the business owner for a personal guarantee since he’s not “only renting it to the business, but to the owner.”
What’s the maintenance and management process for residential and commercial properties? Which one requires you to be more hands-on?
When it comes to maintenance and management, there are two approaches investors can choose: DIY or hiring a property manager. Nicely and Hills both use property managers and suggest investors, especially those with large portfolios, do the same to reduce the day-to-day workload.
“There’s a tipping point of where you feel overwhelmed,” Nicely said in a previous Inman article. “And there’s another tipping point to where you’re making enough money to where it makes enough sense to pay [a property manager].”
“The reason why we’re real estate investors is so we can live our best life now instead of in 40 years when we retire,” she added.
Between commercial and residential, Nicely said the maintenance and management process is easier in commercial since business owners take responsibility for the everyday operations, whereas single-family or multi-family tenants will depend on you to answer questions and make repairs.
“Most times in commercial, tenants are going to take care of the maintenance, they’re going to take care of the interior and exterior and they’re not going to call me every time a lightbulb needs to be changed,” she said. “I want to give tenants the chance to run their business the way they want to.”
In either industry, Hills believes the key to great management is courtesy and respect.
“The No. 1 keeper of tenants is courtesy and respect,” he said. “Go ask tenants if they like their landlord, and most of the time they’re going to tell you ‘no.’”
“They’re going to tell you they’re unresponsive, they don’t care, and they don’t fix issues. They just show up when its time to collect rent,” he added. “When you treat tenants with common decency and fix their issues, they stay longer. The number one cost of renting, commercial or residential, is vacancy.”
What about the return on investment? Which investing option offers the least risk and best short or long-term success?
“It’s a tough one,” Hills said regarding the process for calculating a reasonable return on investment.
Although he recognizes a “reasonable ROI” will vary from investor to investor based on goals and local market trends, Hills said a good starting point is aiming to meet the cash-on-cash returns that you’d see on the stock market, which is currently anywhere from 7 to 9 percent. However, after factoring in debt reduction and property appreciation, Hill said he “wants to crush the stock market.”
While Hills thinks of ROI solely in terms of cash-on-cash returns, Nicely pushes investors to add time to the equation.
“Go for commercial, especially if you’re only concerned about the return on investment,” she said. “Your time invested in commercial will be less than residential. Your emotions will be invested less in commercial than residential.”
“If you have any experience in business, go for commercial [instead of] residential,” she added.
When it comes to risk, both investors agreed multi-family housing is the best option since rental demand is consistent and there’s multiple streams of cash in the form of rent.
“As a new investor, you have to decide if you want one door versus 14,” Hills said. “If that one door goes vacant or you have to evict that tenant, it gets really expensive because you have to cover those costs out of pocket.”
“If you have 14 doors, and one unit goes vacant, it’s not fun, but you don’t have to cover the mortgage out of pocket because you have 13 other doors of people paying rent,” he concluded.
On the other hand, Hills said retail and office space currently offers the most risk as both industries are experiencing great disruption.
“Personally, I don’t want to buy retail space and I don’t want to buy office space,” he explained. “I don’t want to compete against Amazon, and as an investor, why would I? For example, if you’re a pharmacy right now, you better be scared to death of Amazon droning pharmaceuticals right to consumers’ doors.”
“When it comes to office space, you think about the WeWork [model] and telecommuting. It just seems risky.”
In terms of short-term and long-term success, Nicely and Hills said investors should only make purchases based on potential long-term gains.
“I don’t have any control over what’s going to happen in the world markets,” Hills said. “If you’re buying for the short-term, you’re just speculating and gambling.”
“If you want to gamble, you can just go to Vegas. It’s way more fun. I only buy for the 15, 20, 25 year range.”
Lastly, which option offers the best opportunity for selling and scaling?
Hills and Nicely suggest investors take a simple approach to scaling: smart small and only diversify when you have the cash flow to sustain it.
However they differ when it comes to selling — Hills doesn’t mind offloading properties, while Nicely prefers to keep every property she buys.
“I don’t believe in selling,” she said. “You can only sell it once, but you can rent it forever.”
If you don’t want to take Nicely’s approach, Hills said single-family or small multi-family residential is the easiest to offload.
“Residential is always easier to sell because there’s more buyers,” he said. “Just remember, the bigger and more expensive it is, the harder it is to sell.”