Discover the world of commercial real estate investing, how it differs from residential real estate, and how it accelerates your journey to financial freedom! Clint Harris and Neil Henderson break down the key differences between residential and commercial real estate and reveal why the latter can be a game-changer for savvy investors.

You’ll learn about the unique valuation methods for commercial properties and how understanding cap rates can unlock incredible potential for wealth creation. Clint and Neil also discuss the role of business plans, operator trust, and your ability to analyze opportunities when evaluating commercial real estate investments.

Don’t miss this episode packed with valuable insights that can help you make informed decisions in the commercial real estate market.

Key Takeaways

  • Commercial real estate is focused on business properties, while residential real estate is primarily for living spaces. The latter includes single-family homes and smaller multi-family properties, while commercial real estate encompasses residential properties with five or more units, retail spaces, office buildings, self-storage, and other business-related properties.
  • The valuation methods for commercial and residential real estate differ significantly. Residential real estate is valued based on comparable sales, while commercial properties are valued according to their potential income generation, utilizing cap rates and net operating income.
  • Forced appreciation is a critical concept in commercial real estate, allowing investors to increase property value through strategic improvements and management. This level of control is not as prevalent in residential real estate, making commercial properties more attractive for those seeking passive income.
  • Cap rates, or capitalization rates, are used to measure the potential return on investment in commercial properties. They are calculated by dividing a property’s net income by its value, providing insight into the expected annual return.
  • Net operating income (NOI) is the gross income a property generates minus its expenses (excluding mortgage payments). The NOI is a crucial metric in commercial real estate valuation, as it directly impacts the cap rate calculation and property value.
  • Understanding how commercial properties are valued and the factors that can increase their net operating income is vital for evaluating potential investment opportunities. This knowledge allows investors to analyze business plans and determine the likelihood of successful value-add strategies.
  • Partnering with experienced operators is essential for success in commercial real estate investing. These experts can help identify opportunities, execute value-add strategies, and manage properties, allowing investors to reap the benefits of passive income without the need for hands-on involvement.

Time Stamps

[00:00] Intro

[01:29] Introducing Clint Harris and Neil Henderson

[02:15] The key differences between commercial and residential real estate

[04:12] Explaining valuation methods for residential properties

[05:45] Discussing the forced appreciation concept in commercial real estate

[07:21] The importance of understanding cap rates in commercial property valuation

[10:10] The role of net operating income in commercial real estate

[12:22] Evaluating opportunities and sponsors in real estate syndications

[15:03] The potential for massive value swings in commercial properties

[17:37] Why understanding commercial real estate is crucial for passive income investors

[21:54] Summary of key differences between commercial and residential real estate

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Transcript
Neil Henderson:

Are you struggling to find a way to generate passive income through real estate investments? What if we told you there's a world of opportunities in commercial real estate, far beyond traditional residential properties. In this episode, Clint Harris and I explain the difference between commercial and residential real estate investing. Unlocking the secrets to creating truly passive income by understanding asset valuation, cap rates, forced appreciation, and partnering with skilled operators. Don't miss this game-changing conversation that could transform your passive investment strategies and help you achieve financial freedom. Welcome to the Truly Passive Income Podcast. I'm Neil.

Clint Harris:

And I'm Clint. Today on the Truly Passive Income Podcast, we're gonna be talking about the differences between residential and commercial real estate. Now, I know that it seems that we've had a pretty big focus on real estate right off the bat. We're not always gonna be talking about that. We're gonna explore a lot of other things and everything that's truly passive, but specifically, uh, real estate is an asset class that for thousands of years has been proven to generate passive income all across the globe. So that's one of the things that keeps rising to the top and in our journey to identify truly passive income. That's something that we're gonna continue to have focus on. And to do that we want to educate you on some of the basic principles, definitions, and understanding about some of the things specifically within real estate that are helpful in generating truly passive income. Neil today, why don't you start us off give us an introduction of the differences between residential and commercial real estate.

Neil Henderson:

Yeah. So as we're indicating there's two primary, categories of real estate, and that's residential and commercial, and there's some really key differences that we want to define for you and explain for you. I think it's very important for you to understand when you are looking to invest passively in this asset class. Some of the key differences. First is the purpose, with residential real estate. Residential is generally used for living, whereas commercial is generally used for doing business. Now there's a couple of ways where they cross over, but that's the general, high level differences. They also have different owners. They typically have different buyers and they have different sellers. and they also, have different types of financing. A residential mortgage is typically very different from a commercial mortgage. and then finally, we're gonna talk about the ways in which they're valued. Residential real estate is valued very differently from the way that commercial real estate is valued. Clint, why don't you dig a little bit deeper into how we define residential versus commercial real estate.

Clint Harris:

So residential real estate is typically what most people are familiar with because we all have to have a place to live. So if you're a homeowner, whether it's a town home or a condo, single family home, anything like that, that's traditional residential real estate. It's used for living. The most common type across America is obviously a single family home, but it can also be a small multifamily home, duplexes, triplexes, or quadplexes. Typically residential and residential loans. For residential real estate can be anything four units or less, but it can also be things like a vacation rental. So a residential property that's being used for Airbnb, that still counts as a residential property. So usually anything four units or less, that's a vacation rental. Also, including condos and town homes, even if the building itself may be owned, but the land is not. That's all traditional types of residential real estate and a lot of those can be used for passive investing and different types of real estate investing, not all of which are passive on top of that the real difference is that with commercial real estate, the valuation and what the building is used for is completely different. So commercial real estate is typically used for business. It can include some residential properties if they're also used to generate rental income, things like that. But more traditionally, when you think of commercial real estate, you're thinking about office buildings, retail stores, strip malls and centers, warehouses, industrial buildings, self storage facilities, apartment complexes, or honestly any multifamily that's five units or larger or mobile home parks, things like that are some of the more common, things that we think of in terms of the core definition of what is commercial real estate. Neil, why don't you tell us about what some of the differences are.

Neil Henderson:

Sure. as you talked about some of the types of buildings, again, residential is typically used for living, whereas commercial is typically used for business. But sometimes that business is providing a place for people to live. In that case I'm talking about apartment buildings, and that's, typically it's classified, five units or more is gonna be classified as a commercial not a residential building anymore. And this is where you're talking about, apartment buildings and apartment complexes and things like that. And some of the other things are who owns them. So with residential, it's typically families or individuals who need a place to live, whereas with commercial, it's typically owned by businesses and or investors, looking to generate income or for a place for them to do their business. And these buyers and sellers, there's also different buyers and sellers for different types of Two asset classes, and they have different motivations. Now with residential real estate, you're typically talking families or individuals who need a place to live. they're gonna be motivated by personal factors, things like location, proximity to employers and schools. Schools is a huge one when it comes to residential real estate. they're also looking at the size. Someone just out of college who's single and not married has very different needs as far as the size of place to live than, a married couple with two kids, three kids and a dog. they're also gonna be motivated by amenities on the property. Does it have a pool? does it have a large yard? Is it close to parks? Is it close to the kinds of things that they want to do? Is it close the beach is close to a lake, whatever. With commercial, you're primarily composed of investors and businesses looking to buy or lease the property for their operations. They're gonna be motivated by much more financial considerations. Things like, what is the potential income that this property can produce? Is there a potential for them to increase the income? Is there a potential to decrease the expenses on the property? Which would then increase the overall income. And then is there an opportunity for them to improve the operations at that site. Finally, not finally, but also as far as location, they're looking at their access to customers and suppliers. They're gonna be much more interested in the visibility of a building, is it on a main street where there's a high traffic count, is it highly visible from the road? Does it have easy access for customers to get in and out of that area? How close are they to their suppliers? If they're a shipping company are having to move all the way across the country and it's gonna cost them a lot of money, that's gonna be a factor that they're gonna think about. and then finally, The size of the building, what scale do they need to operate? Obviously, a small mom and pop retail, company is gonna have very different needs than a large shipping company that needs a lot of warehouse space and things like that. There's also a major difference in the way that financing works between residential and commercial real estate. a lot of people are very familiar with the way that residential mortgages work. It's based on the credit worthiness of the buyer and their ability to pay the monthly mortgage. It's also based on the evaluation of the property by an appraiser at the time of closing, and it's typically a 30 year mortgage with a 30 year term at a fixed rate with 20% down if you are going to live in the property. Now, there are cases where you can put less down. There's FHA loans that require less, you can put as little as 3% down. There's VA loans where they can get in for almost zero down. but for purposes of here, we'll get into more detail on that later. It's typically 20% down if you're buying it as an investment property, the lender's typically require you to put 25% down. Now with commercial, it's based on the projected income of the property and the experience of the borrower. It's not so much on their ability to pay, but it will sometimes require a key principle with enough net worth to cover the loan, to make the lender feel comfortable. If you are brand new to the storage industry and you go out there and you find a great storage facility that you wanna acquire, and it's gonna require a 2 million loan for you to buy it, and you have no experience in self storage, the lender's probably gonna want some person to sign on a loan that has some sort of experience in the self-storage industry, to give them a little more comfort that you're not gonna just screw this up. With commercial, there are many different types of lending, and I'm not gonna go into a whole lot of detail on these yet. But there're bridge loans, there're construction loans, there are things called mezzanine loans, and there's also much more varied terms when it comes to commercial lending. Uh, They're often shorter terms, they'll often have 25 year amortization, meaning that the payoff period will be 25 years, but they'll often have a balloon payment due in anywhere from five to 10 years. And that, we won't get into detail here, but that becomes very important when you are investing in a deal to understand when that loan is due, because, you don't want to have to pay off a loan when the market cycle is doing something you don't want to do. And then finally, there's typically a higher down payment. It's typically 25 to 30%, but again, there are things called SBA loans, small business administration loans where you can, get in for a lower amount. And it can also often be a variable rate. you'll, you're typically not going to have a fixed rate. A lot of times you can get into a commercial loan, especially construction loans, where it will be an interest only period for anywhere from two to three years. And then it will go to, a full repayment schedule. Clint, why don't you talk about the different ways that we value residential real estate, and then I'll talk about different ways we value commercial real estate.

Clint Harris:

Neil that was excellent, and I think really going through those key differences leads us up to the point in the discussion where we are now, which is the valuation on the property. And this is what I would say is the real meat of the discussion today. We're trying to be very high level with this episode and bring a little bit of education in terms of residential and commercial real estate but here's the key. If you understand the things that you just went through, the different types of financing. The underlying principle that real estate investors talk about all the time, and it's become really a buzzword, is value add. People talk about any type of property that has some type of value add in their ability to increase the value of the property. The key to that, in my opinion, is understanding how the property is valued and the key differences that you just went through with residential and commercial real estate also have very key differences in the valuation on the property. So the most common one that most people are familiar with is the valuation on residential real estate, which is typical if you've ever bought a home or your parents owned a home growing up, it went through the process of the valuation, typically by an appraiser. If you go through the regular mortgage process is established based upon the location of the property, the size, usually the square footage, the number of bedrooms and bathrooms, and the condition of the property. So what's going to happen? My wife is a full-time real estate agent, and when someone goes under contract on the property, they're gonna typically get a loan. A lot of times in our market, they may just pay cash, but in most markets, they're gonna get a loan for the property. The value of the property can be estimated by the real estate agent. They run what's called a CMA or a comparative market analysis. Some people will call it comps. They're gonna run the comps and look at, okay, in this location, a house with this number of bedrooms and bathrooms, that's this far from X, Y, Z amenities, and it's in this school district. You're comparing it to three, sometimes more properties that have sold in that area, a similar neighborhood within the last six months, and you're looking at the value of the bricks and the sticks of where it is, what it is, of the condition and everything like that. So it's gonna be based upon what else has sold in the last six months or so, and sometimes when the market is really shooting up fast, it can be hard for those appraisals to keep up with it. we just went through a period where the market was appreciating so fast that if you were looking at homes that sold six months ago, the prices were 20 to $30,000 higher. And so a lot of people were having to pay cash to make up the difference there. But basically that's the valuation of residential real estate. And so when it comes to things like flipping properties or fixing properties up and rehabbing them or increasing the value of the property. The way that you're gonna do that is by adding amenities, expanding, adding on additional rooms or adding square footage or just overall bringing the property up from a B level property to an A level property, things like that. So this gets back to what we've talked about before, is the concept of appreciation. And you've got natural appreciation of buying in the right area where the school district continues to get better and better. Or maybe you get rezoned into a new school district and then suddenly the value of the properties in that area are gonna go up. So there's things like natural appreciation that you can try to be aware of by being in the path of progression. But there's also things like forced appreciation and that's where you're fixing the property up. You're putting in new granite countertops, stainless steel appliances. You're ripping out the carpet, you're putting in LVP flooring and things like that. It also can, because some residential properties can be Airbnb or vacation rental properties. In those smaller properties, you can also fix the property up and increase the forced appreciation by maximizing the rental income. So those are the basic ways that, that a house or single family home or residential real estate is gonna be valued. An appraiser's gonna look at the condition, the location, and the market, and they're gonna tell you what the property's worth. And the way that you can increase the value is by increasing the size, increasing the condition, and things like that, cuz you can't change the location. You're a little bit limited in how you can affect the valuation on the property. There are certain levers that you can pull to get that done, but it's not nearly as easily influenced as a lot of things are in the commercial space. Neil, you wanna jump in on that?

Neil Henderson:

Sure. And the point Clint is trying to make here is that, I'm gonna go over this, is that, with residential real estate, things are a little more based on the market, uh, a little more, little bit more based on factors that you cannot control, and that's really what it comes down to. With commercial real estate, at a high level, there's just more levers that you can pull that you can control in order to raise the value of that property. So when it comes to commercial real, when you're valuing, you're gonna look at the location and the size, but most importantly, the potential income that it can produce. And that's often how commercial estate is valued, is what is the income it can produce? And if it's a property that is not producing income, if it's just an empty building, you're often going to get into something called price per square. you're gonna basically come up with a, something that sounds fair based on the market, based on that type of asset class and that market, and that's what you're gonna buy it on. But what we're gonna focus on here right now is on when they value it based on income, and they'll use something called the market cap rate. And cap rate stands for capitalization rate, and I'll define that in a second. divided by the net operating income. And net operating income is the gross income that a property produces, minus its expenses, not including debt service, so not including the mortgage. So if a property produces $200,000 annually In gross income and it has a $100,000 in expenses, you would say that its net operating income is a $100,000. Now, A cap rate, capitalization rate. A cap rate is a way to measure how much money an investor can expect to make from a property, and it's calculated by dividing the property's net income by its value. And cap rates are used to help people decide whether or not to buy or sell a commercial property. The value of a commercial property is based on the cap rate, which can change depending on various factors such as interest rates, the type of property, the market. It's the closest thing that can be defined for me as what you would call a comparative market analysis, is how it reflects back to residential real estate. And cap rates are an important thing to consider when buying, when evaluating a commercial property. But it's not the most important. It's not the be all end all, but basically the way you can look at it is; a cap rate is how much money you're going to make on the property if it has no debt. So for instance, if it's a $1,000,000 property, you've bought it for a $1,000,000 cash and it has $200,000 in gross income, a $100,000 in expenses, it produces a $100,000 annual income. Then you would say its cap rate is 10%, a $100,000 divided by a $1,000,000. Now, that's very high level, and we'll go into more detail at a later time, but that's basically what you need to understand about the way that commercial real estate is valued.

Clint Harris:

Right. One of the reasons that's so important is a lot of times it's not about calculating the cap rate. It's understanding at what cap rates certain asset classes are trading at, whether it's self storage or a mobile home park. They may be trading at an eight cap or things like that. So typically what you're looking at the cap rate is the net operating income divided by the sales price. The real key there is that if you understand that equation. Is very easy to manipulate. You can increase the net operating income and at the same cap rate, it can drastically increase the value of the property. And again, we'll get into that a little bit deeper, but that's just one example of that definition we're gonna talk a lot more about and it's gonna become more clear. But the question is, why is it important for you to know this? We're going through a lot of definitions and differences between residential and commercial real estate. Here's why. Passive income comes from investing in other people's businesses or in properties where you can control the value in a fixed and known way. The cap rate is the net operating income divided by the sales price of the property. So if you buy the property for a million dollars, but then you can double the net operating income. At the same cap rate, you just doubled the value of the property, potentially depending on the purchase price. But the reason it's important for you to know how the differences in the asset classes and how they are valued is so that when it comes to the forced appreciation and your ability to control the value of that property or investing in someone else's business, you know how to ask the questions of how they can control the. So in the world of, specifically in real estate syndications, the hardest part is evaluating the opportunities that are out there. You're looking at the sponsors, you're looking at the projects and things like that. The key to understanding what you're looking at and whether they are good deals or bad deals is understanding the business plan. Understanding the way that the asset class is valued and understanding what levers can be pulled in terms of value add, or expansion or business operation, that can increase that net operating income and increase the value of the property because the increase in the value of the property along with the cash flows is going to equal your returns. And that's why it's so important for you to understand the difference in residential and commercial real estate. There's very little you can do to change the value of a residential property. There's a lot you can do to change the value of a commercial property. If you understand that and the way that the property is valued and the business plan that's going to be executed on the property, you can estimate what the increase in value is gonna be, which along with the cash flows is going to determine what your income is. And once you have the ability to understand the valuation and trust the operator, it puts you in a position where they can use their time and experience. You invest your capital and if you have done the analysis appropriately, it should increase your value and be a completely, truly passive investment for you.

Neil Henderson:

Gotcha. All right, so I'm gonna just wrap up what we covered here. just review it a little bit. So again, there are really key differences between residential and commercial real estate. again, residential is typically a place to live. Commercial is a place to do business. It's typically, except when it comes to residential, that is five units or more, and that's, an apartment building. The key differences are the types of buildings, the types of buyers and sellers and how they're financed. They're also valued in a very different way, which we just covered. Residential is valued by the comps sold within, let's say, the last three to six months within a certain radius, whereas commercial is valued by the income it produces divided by the capitalization rate of that asset class in that market, or if it's a completely vacant building, it can also be valued by its price per square foot. The ways in which you can increase the value of commercial real estate are much more concrete and repeatable. And that's why you're gonna hear us keep coming back to talking about that cause that's really what is so attractive about commercial real estate. Alright, so there you have it. That's the basic difference in residential real estate. Clint, did you have anything to add before we go?.

Clint Harris:

I think that you did a great job of wrapping it up. The real key is going to be that value add that you just mentioned, that the valuation of the building comes from the net operating income and the purchase price of the building or in the cap rate. But if the building is empty, The valuation may just be on the brick and mortar, just the empty building sitting there. So your ability to turn an empty building into a building that has a tenant in it or a business in it that's generating net operating income has the potential to vastly increase the value of that property depending on what the net operating income is. And anytime you see a big value delta like that change, from basically an empty building to an operating business. The building can be sold or refinanced as a business now instead of just the brick and mortar that has potential income to create a massive value swing. And anytime there's a massive value swing that delta, that middle ground, that's where you're making your money. And as long as you find an operator that knows how to do that, It puts you in a position to recognize opportunity and partner with those people to create some truly passive income.

Neil Henderson:

All right. listen, thank you so much for listening to this episode of the Truly Passive Income Podcast. If you liked the show, if you think it would be useful for someone else, the greatest compliment you could give us would be to share this episode with someone you know, or leave us an honest review wherever you listen to podcasts. If you have any questions, don't hesitate to send us a message on Twitter @TrulyPassive and remember. With truly passive income comes freedom of time place and the freedom to pursue your higher purpose.