Investing in Small Commercial vs. Residential Real Estate

One of my commercial tenants skipped out on me earlier this year, so I have my office building on Manchaca Rd. for rent again. I knew it could possibly take 6 to 12 months to find a new tenant, and so far, even after dropping the rent from $1,700 to $1,495, I still don’t have it leased. Bummer.

This unfortunate reality is one of the first big differences between owning small commercial investment property versus single family homes in Austin. It would never take 6 to 12 months to rent a house (well, if you have a lousy Austin property manager it could I guess). But extended vacancy is not unusual with a commercial property, especially in this economic climate. Meanwhile I am absent the $1,700/mo. rental income that the former tenant, a tow truck company, provided. Ouch.

Ironically, I could have leased this property immediately, which would have been a streak of incredible luck, but I decided I didn’t want the type of business that the business owner wanted to set up. This is the second big difference in owning commercial investment in Austin versus residential rental property, making sure the tenant is a good fit for the property and the community.

The tenant prospect wanted to open up a “gaming room”. I wasn’t even sure what that was until I looked into it a bit more. It’s legal, apparently, but I just don’t want 40 or 50 of these gaming machines, which are a cross between bingo and slot machines, in my building, with gambling addicts sitting in front of them till midnight smoking, guzzling coffee and blowing their money trying to win Visa gift cards. It just doesn’t seem like an activity that adds value to the community of Manchaca, or society in general, so I don’t want to be involved by providing the venue. And I worry that even if the business is technically legal at present, our friends down at the Texas State Capital, who have a fondness for trying to legislate morality, might change the laws and cause me a vacancy. So I passed on the quick lease-up for personal reasons.

With residential property, you can’t do that. Applicants either qualify or they don’t, and even if the applicant owned a business I don’t like, it would be improper for me to decline rental on that basis.

Plus, that’s too many gamblers flushing my commodes in a property serviced by a 30+ year old septic system. On the other hand, the $15K in lost rent between then and now would have paid for a brand new septic system.

So, in a nutshell, this small commercial investment property is a cash cow when it’s leased. I paid $58K cash for it in 1998, and immediately invested another $17K remodeling it, so I’m in $75K for a property that was paying $1,700/mo. rent until it went vacant. Not a bad return. I can’t buy anything today that even comes close to that kind of ratio. Plus, it’s appreciated nicely to a value of about $250K today, and it’s located in the fastest growing zipcode in Austin, 78748. Had I invested that $75K in the S&P 500 10 years ago, I’d still have about $75K. Today, rent proceeds plus equity buildup make this a good investment.

But when it’s vacant, it stays vacant for a long time. Much¬†longer than a typical house. As an investor, if you’re thinking about small commercial, you have to ask yourself if that’s ok. Can you handle extended vacancy or will it drive you crazy? I’m in it for the long haul and the vacancy, though unwanted, is just part of the business of investing in small commercial real estate, so it’s not upsetting or distressing to me given the return the property has already produced. But I don’t think the average small investor wants to own a property that is this difficult to rent. It’s high return, high risk and I think most small investors would prefer a more predictable real estate investment.

The other good thing about small commercial is that there are no repair hassles. The tenant who just left was there for over 5 years and I didn’t spend any money at all on repairs because, in the commercial lease, the tenant is 100% responsible for all repairs and maintenance. On the other hand, my eventual new tenant might want to negotiate thousands of dollars in finish-out or remodeling of the property, and I have to be ready to negotiate that. That could amount to a number much greater than 5 years of residential rental repairs, so, again, it’s great when the property is occupied, and it’s financially uncertain when it’s not.

In the end, I think most of the better cash flow of the small commercial rental property is eaten up in vacancy loss and potential build-out allowances, but I still like having a mix of residential investment properties and commercial.

I also have an office condo that I purchased brand new in 2007. That one took 6 months to lease and I had to give a $2,400 rent concession the first year on a $1,600/mo. lease. That’s the equivilent of a $12K hickey right out of the starting gate. But, when rented, this property also performs much better than any residential rental home I could purchase. I paid $150K and it rents for $1,600/mo. A $150K residential investment property in Austin would rent for $1,200/mo. +/-, so the question is whether or not the additional $4,800/yr in rent offsets the greater vacancy loss. If I keep this first tenant for 2.5+ years, it will, and then some, and it looks like that will happen. If I have a turnover before then, it won’t.

But remember, I have no repairs or maintenance costs with this commercial condo. No tenant hassles either. It’s on auto-pilot, which is really nice compared to a rental home. And my property insurance is only $500/yr. (though I do have an HOA fee) But, like the other property, this condo could go vacant and blow a big financial hole in the overall return if it stays empty for an extended period.

In Summary, I think if you’re only going to own one or two real estate investment properties in Austin, stick to residential houses or a duplex. If you’ve built up a small portfolio of residential and wish to diversify, small commercial rentals are a good addition to a real estate investment portfolio, but you have to make sure you have at least a year of reserves or that your residential properties provide enough cash flow to carry the commercial properties through the vacancy periods. Commercial ups and downs are not for the feint of heart.

Also, residential is much easier to dispose of quickly if you needed to sell. Financing is very difficult, especially now, for small commercial, which makes it harder to sell. On the other hand, if you are a solid buyer and able to obtain a commercial loan, you have good leverage in this market as you might be the only qualified buyer your seller will encounter for the next 12 months. Austin Telco Credit Union has good commercial loans with low closing costs and rates in the 6% range.

Finally, why didn’t I just put all this in a spreadsheet and create a side-by-side comparison of a Rental House vs. a Small Commercial investment property? Mainly, because I don’t evaluate my purchase decisions with spreadsheets. I think spreadsheets cause more bad real estate purchase decisions than good ones for real estate investors. Maybe I’ll cover that topic in another blog soon. But put away the spreadsheet and use your common sense, math you can do in your head, and gut intuition and you’ll outperform your spreadsheet-worshiping real estate investor counterparts over time, I promise.

3 thoughts on “Investing in Small Commercial vs. Residential Real Estate”

  1. Completely agree on this.

    My small commercial building was vacant for six months and that hurt. But now that it is leased, it is on auto-pilot for 3-5 years, and it’s great.

    The residential properties have less overall vacancy, but they turnover about once every 1.5 years, on average.

    I think small residential may actually be less attractive of an investment when factoring in expensive leasing commissions, inevitable maintenance costs, and the fact that I need a property manager to deal with the headaches of a 24/7-lived property.

    My current thinking is that mid-sized multifamily might be better than both of these options. You get economies of scale with management expenses, and the price per door is less than with duplexes.

    The key is getting a low enough price to guarantee positive cash flow after all expenses. From what I see and hear – this cannot yet be accomplished in Austin at the current still-high prices. There haven’t been many distressed sales in this category, either, because more renters are in the marketplace.

    I might be wrong, but 78704 or 78745 multifamily, if purchased at the right price, may be the best investment out there right now. That’s what I am looking for, anyway.

  2. Thanks Robert.

    You and I have talked before about the pros and cons of management-intensive high margin investments (duplexes/4plexes) versus homes with lower cash flow but which attract better quality, lower hassle tenants.

    The vacancy issue with small commercial is a similar sort of “choose your poison” Catch-22. Cash flow is great but the vacancy is terrible.

    But I have to say, as much as I don’t like vacancy, and as costly as it can be when it’s happening, it’s more tolerable to me than dealing with a succession of lousy tenants, evictions and maintenance headaches. I don’t have any of those issues with the small commercial, just the vacancy problem when it happens.



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