You may have heard that I’ve started the process investing in my very first commercial investment property. This will be the beginning of my migration away from residential rental properties in my portfolio. After learning some of the key differences and advantages of commercial rental properties, I’ve made the decision to transition to commercial rental investment properties within my real estate portfolio. These past several months I’ve been learning so much and I’m excited to continue to learn how to best to invest in commercial real estate. I’m hoping to take my real estate investing to the EXTREME! \m/ \m/

I do believe that by Investing in real estate, it can be a proven strategy for building wealth and generating passive income. However, one of the most significant decisions investors face is whether to invest in commercial or residential rental properties. The latter is what I have been investing in since 2017. While both types of real estate can have their benefits, they also come with distinct risks, responsibilities, and financial rewards. In this article, we’ll explore the advantages of commercial investment rental properties compared to residential rental properties, explain the concept of triple net leases (NNN), and cover some essential terminology like CAM (Common Area Maintenance) that every investor should know.

Understanding Residential vs. Commercial Rental Properties

Before diving into the specifics, it’s can help to understand the basic differences between residential and commercial rental properties.

Residential Rental Properties: These include single-family homes, duplexes, townhouses, condos, and apartment buildings. These types of properties are rented out to individuals or families for long-term or short-term living purposes. Residential investments are typically considered more straightforward and less capital-intensive, making them a popular choice for first-time investors.

Commercial Rental Properties: These properties are used for business purposes and include office buildings, retail spaces, warehouses, industrial facilities, some medical or healthcare facilities, and multifamily apartment complexes. Commercial properties often require a more significant initial investment and come with more complex management responsibilities. However, they also offer the potential for higher returns and longer-term leases.

Advantages of Commercial Rental Properties Over Residential Properties

While residential rental properties can be a solid investment, commercial rental properties offer several advantages that may make them more appealing to experienced investors.

Higher Income Potential

One of the most significant advantages of commercial rental properties is their potential for higher income. Commercial properties typically generate more revenue than residential properties due to larger tenant spaces and higher rental rates. Additionally, commercial leases are often longer-term. Some can be 15-year lease terms. This can provide a more stable and predictable income stream.

For example, a retail strip mall with multiple tenants can generate significantly more rental income than a single-family home. Even when factoring in higher costs, the net operating income (NOI) from commercial properties is often much higher than that of residential properties.

Triple Net Leases (NNN)

One of the most attractive features of commercial real estate investment is the potential to utilize what is called a triple net lease (NNN). In a triple net lease, the tenant agrees to pay all the property’s operating expenses, including property taxes, insurance, and maintenance costs, in addition to the base rent. This arrangement shifts much of the financial burden and risk from the landlord to the tenant, making it a highly advantageous structure for property owners. Those of you that have residential rental properties, you can start to see the advantages here.

Why Triple Net Leases Provide Advantages

Lower Landlord Expenses: Since the tenant is responsible for most, if not all, of the property’s operating expenses, the landlord’s costs are significantly reduced. This can lead to higher profit margins and less financial risk for the property owner.

Predictable Cash Flow: Triple net leases often involve long-term agreements (typically 10-15 years), providing a stable and predictable cash flow for the landlord. This consistency makes it easier to plan for future investments and expenses.

Lower Management Responsibility: With the tenant handling most of the property’s upkeep and expenses, landlords of commercial properties with NNN leases enjoy a more hands-off management experience. This can be particularly appealing to investors who prefer to take a more passive approach.

Diversified Tenant Base

Another advantage of commercial rental properties is the potential for a diversified tenant base. In a commercial property like a shopping center or office building, multiple tenants may occupy the space. This diversification reduces the risk associated with tenant vacancies. If one tenant leaves, the impact on your overall income is minimized because other tenants are still generating rent.

In contrast, residential properties are typically occupied by a single tenant or family. If that tenant moves out or defaults on rent, the property owner could face a significant loss of income until a new tenant is found.

Appreciation Potential

Commercial properties often have a higher potential for appreciation compared to residential properties. This is because commercial real estate values are largely determined by the property’s income-generating potential, rather than just market trends. By increasing the NOI through higher rents or better tenant management, property owners can significantly boost the property’s value.

Professional Tenants

Commercial tenants are usually businesses, which tend to be more stable and reliable than individual residential tenants. Businesses have a vested interest in maintaining a professional appearance and staying in one location to build customer loyalty. This stability can lead to fewer vacancies, lower turnover, and less wear and tear on the property.

Key Terminology in Commercial Real Estate Investment

When investing in commercial real estate, it can also help to understand some key terminology that is commonly used in the industry.

A Triple Net Lease (NNN)

As previously mentioned, a triple net lease (NNN) is a lease agreement where the tenant is responsible for paying the property taxes, insurance, and maintenance costs in addition to the base rent. This lease structure shifts most of the financial responsibilities from the landlord to the tenant, making it a favorable option for commercial property owners.

Common Area Maintenance (CAM)

Common Area Maintenance (CAM) refers to the costs associated with maintaining and operating the common areas of a commercial property, such as lobbies, hallways, parking lots, and landscaping. CAM expenses are typically shared among the tenants in a commercial property based on the amount of space they occupy.

For example, in a shopping center, tenants may be responsible for their proportionate share of the CAM expenses, which could include costs for landscaping, snow removal, security, and lighting. CAM charges are usually billed separately from the base rent and can fluctuate based on actual expenses.

Net Operating Income (NOI)

Net Operating Income (NOI) is a key metric used to evaluate the profitability of a commercial property. It is calculated by subtracting all operating expenses (excluding mortgage payments and capital expenditures) from the gross income generated by the property.

NOI Formula:

NOI = Gross Rental Income – Operating Expenses

A higher NOI indicates a more profitable property, making it a critical factor in determining the property’s value and investment potential.

Cap Rate (Capitalization Rate)

The capitalization rate, or cap rate, is a measure used to estimate the return on investment (ROI) for a commercial property. It is calculated by dividing the NOI by the property’s current market value or purchase price.

Cap Rate Formula:

Cap Rate = NOI / Property Value

A higher cap rate suggests a higher potential return, but it may also indicate higher risk. Investors often use the cap rate to compare the profitability of different properties and make informed investment decisions. Keep in mind, the cap rate can be variable base on a variety of factors. Things like specific location, type and condition of property, quality of tenant as well as local economy and market condition can affect the cap rate.

Gross Lease

In what is called a gross lease, the landlord is responsible for paying all property expenses, including taxes, insurance, and maintenance, while the tenant pays a fixed rent amount. This lease structure is more common in residential properties but can also be found in some commercial leases.

Modified Gross Lease

On the other hand, a modified gross lease is like a hybrid between a gross lease and a triple net lease. In this arrangement, the tenant and landlord share the operating expenses, with the tenant typically responsible for utilities and janitorial services, while the landlord covers property taxes, insurance, and maintenance.

Making the Right Investment Choice

Investing in real estate, whether residential or commercial, can be a lucrative way to build wealth, accelerate your path to financial freedom, and generate income. However, understanding the differences between these two types of investments is crucial to making an informed decision.

Commercial rental properties offer several advantages over residential properties, including higher income potential, the benefits of triple net leases, diversified tenant bases, and appreciation potential. However, they also require a more significant initial investment and a deeper understanding of the commercial real estate market.

For investors willing to take on the challenges of commercial real estate, the rewards can be awesome! By understanding key concepts like triple net leases, CAM, NOI, and cap rates, investors can make smarter decisions and maximize their returns. Whether you’re just starting in real estate or looking to expand your portfolio, commercial properties present an opportunity to achieve significant financial growth while enjoying the benefits of a more passive investment strategy. Keep those horns up, investors! \m/ \m/