UNDERSTANDING THE DIFFERENCES BETWEEN RESIDENTIAL AND COMMERCIAL REAL ESTATE
Written by Liam McNeilly, Editor
When you read “real estate,” what image comes to mind? Are you thinking about apartment buildings and other multi-unit complexes? Perhaps you are imagining the commercial properties of a downtown core. Or maybe you picture the house you grew up in.
Everyone has a different idea of real estate and what comes to mind when discussing investing in it. Today, we are going to delve into the different types of real estate as well as the pros and cons of certain asset classes.
Before categorizing and exploring different property types, it is worth spending the time to define the concept of an asset class, and where real estate fits within that concept.
Various definitions exist online, but broadly speaking, an asset class is a category of financial instruments that share characteristics and exhibit correlated appreciation trends in public markets (Understanding Real Estate Asset Classes and Property Types, 2024). Basically, groups of related assets that follow similar trends. For example, stocks, bonds, and alternatives are asset classes.
Real estate is an asset class that exists within the umbrella of alternative assets. Within real estate itself exists two primary classes of properties: residential and commercial.
Residential Real Estate
Residential real estate defines any property that serves the primary use of providing shelter.
As the name suggests, residential real estate defines any property that is used for residential purposes, that is, it is used to live in (Chen, 2024). Examples of this include single-family homes, condos, townhouses, and multi-family complexes.
In Canada, a building is only considered residential if it is comprised of four or fewer units. Anything above this threshold is categorized as commercial from a regulatory perspective.
In Ontario, residential properties are governed by the Residential Tenancies Act (RTA), which is focused on protecting the rights of tenants. This act outlines the rules for everything from maintenance requirements and lease agreements to eviction procedures and rent increases (Residential vs. Commercial Real Estate Laws in Ontario, 2024). In cases of dispute, the interaction between the landlord and tenant is adjudicated by the Landlord-Tenant Board (LTB).
The main point to understand about the regulatory framework governing residential investment properties is that it is extremely strict and can be a source of difficulty for many investors. This contrasts with the relatively less stringent regulation of the commercial market, which we will discuss further later on.
Now, what makes this category of real estate attractive to investors? As I am sure you could have guessed, there are a variety of reasons why one might prefer residential real estate over commercial. For starters, residential real estate tends to be more accessible and affordable for new and individual investors (Hayes, 2024). Financing and managing a duplex is, oftentimes, much more straightforward than acquiring and successfully running a multi-story commercial apartment. For many of you reading, the mere idea of purchasing a mid- to high-rise apartment might seem improbable, if not outright impossible.
It is for these reasons that many venture into real estate by getting started in residential rental units.
Residential properties also benefit from greater liquidity than their commercial counterparts (Hayes, 2024). Consider how fast the pool of potential buyers – which dictates how quickly you can sell a competitive asset – shrinks as the monetary value of your property increases. Going back to our previous example, it is much easier to picture yourself purchasing a single-family property or duplex than it is an apartment building.
Demand for residential properties also makes investment in the asset class compelling. A 2023 CMHC report shows that recent vacancy rates have been historically low across Canada (Investment Property, 2024) Last year, purpose-built rentals – rentals designed for long-term rental agreements – had a vacancy rate of 1.5%. Vacancy rates for condo apartments were 0.9%. For context, lower vacancy rates suggest that it will be easier to rent an apartment as well as put upward pressure on housing prices.
Another benefit of purchasing a property classified as residential, especially in Canada, is that your property tax obligation will be lower than a comparable commercial unit (Investment Property, 2024).
In terms of future growth, Royal LePage predicts that the Bank of Canada’s recent interest rate cuts will result in a 5.5% increase YOY in the spring housing market of 2025 (Johnson, 2024). Royal LePage also suggests that the recent decision of the Office of the Superintendent of Financial Institutions (OFSI) to ease stress test requirements for homeowners who are switching mortgage providers will “be material” in terms of price appreciation.
In short, a lot is going for residential real estate.
Commercial Real Estate
Commercial property is an umbrella term for a variety of property types. This includes retail properties, apartment buildings, industrial complexes and more.
Commercial real estate defines any property that is used exclusively for business purposes. This definition includes apartment complexes, grocery stores, hospitals, hotels, and industrial real estate (Chen, 2024). You can think of commercial real estate as encompassing everything that is not a residential building of four or fewer units.
In Canada, property recognized as commercial is regulated by several laws, such as common law and the Commercial Tenancies Act. The focus of these laws is emphasizing the terms of the leases that renters and landlords decide upon (Residential vs. Commercial Real Estate Laws in Ontario, 2024). This means that there is a greater level of flexibility in the creation of a leasing agreement. In the case of a dispute, judicial action is usually the path to resolution.
This increase in regulatory flexibility means that tenants and landlords have a greater responsibility to negotiate favourable lease terms. Rent control, timelines, responsibilities for maintenance and utilities, and eviction procedures are all examples of terms that enjoy relatively greater flexibility.
Despite this greater flexibility on paper, market conditions usually govern expected precedents of lease agreements. Given this, why are investors attracted to commercial investing, especially considering the upsides of residential property discussed earlier?
Due to the added complexity and higher overall risk—such as the greater liquidity risk discussed earlier—commercial properties generally offer higher earning potential and rental yields (Hayes, 2024). Commercial leases across all property types are usually longer-term, meaning a more stable, predictable cash flow to investors. Landlords can even arrange for what is called a “net lease,” where the tenant pays all property taxes, insurance, and utilities on top of a reduced rent (Hayes, 2024).
Continuing this trend of increased flexibility, commercial investors can also look for multi-use zoning to maximize property value and diversify potential sources of rent (How to Maximize Your Commercial Real Estate Investment, 2020). For example, buying a downtown property with residential units built above an attached street-level retail shop. The owner of such a property could collect rent from tenants living in the building as well as the businesses that occupy the retail space.
In terms of predicted upside, given Canada’s current housing affordability crisis, it is no surprise that investors are currently bullish on multifamily residential, a cornerstone of commercial investment activity. The vacancy rate of apartment units is close to 0%, and the average national rent approached $2,185 a month in June 2024 (Lanthier, 2024).
According to CMHC, the country needs to build 3.5 million homes by 2030 to restore affordability, an unlikely feat, to say the least (Lanthier, 2024). While it paints a grim picture for the average Canadian, those interested in commercial real estate should look at these market conditions as incentives to find a way into the market.
Multi-family properties are not the only type of commercial property showing promise in Canada. Investors are also looking towards industrial and retail (Lanthier, 2024). In the industrial market, despite doubling vacancy rates and slight rent decreases, investors agree the market remains a safe bet. The signs of decline have been interpreted as a healthy market approaching equilibrium.
As for retail, Jon Buckley of Marcus & Millichap points to declining vacancy rates and increasing lease rates as signs that retail is regaining its status as a “best-bet” investment (Lanthier, 2024). Commercial investors are focusing on service-anchored retail complexes to drive returns.
All of this is to say that despite recent subpar performance in the Canadian commercial real estate market (Nhieu & Wong, 2024), investors have reason for optimism.
Bottom Line
So, which is better? Unfortunately, it is never that easy. As with most things in real estate and investing, decisions over where to allocate capital come down to individual preference.
One major takeaway from this discussion is that both residential and commercial real estate have a multitude of pros and cons and that comprehensive research and underwriting are necessary for any potential investment. Commercial real estate offers investors greater flexibility and higher potential returns to compensate for the greater complexity and higher risk. Residential properties are typically less intensive to manage and easier to acquire and subsequently scale. Choosing between the two only becomes possible when an investor understands their personal investment thesis and what they would like to achieve with a given property.
Lastly, it is important to note that it is very easy to get lost down the rabbit hole of real estate investing. As you are likely someone interested in maximizing the appreciation of their invested capital, it is important to remember that real estate is only one of many asset classes available to young Canadians to invest in. The stock market, for example, is far more accessible to the average investor and even more so to young Canadians.
Continue to learn and broaden your understanding of the asset classes available to the modern investor, including real estate, so that when it comes time to deploy capital, you can make an informed decision that maximizes your returns while minimizing risk.
Works Cited
Chen, J. (2024, May 31). Real Estate: Definition, Types, How to Invest in It. Investopedia. https://www.investopedia.com/terms/r/realestate.asp
Hayes, A. (2024, January 24). Commercial vs. Residential Real Estate Investing: A Comprehensive Comparison. Investopedia. https://www.investopedia.com/commercial-vs-residential-real-estate-investing-8414678
How to maximize your commercial real estate investment. (2020, December 9). BDC.Ca. https://www.bdc.ca/en/articles-tools/money-finance/buy-lease-commercial-real-estate/5-ways-maximize-your-commercial-real-estate-investment
Investment Property: How to Invest in Real Estate. (2024, April 22). https://wowa.ca/investment-property
Johnson, D. (2024, October 10). Home prices edged higher in ‘sluggish’ Q3, expected to move higher: Royal LePage. BNN Bloomberg. https://www.bnnbloomberg.ca/business/real-estate/2024/10/10/home-prices-edged-higher-in-q3-expected-to-rise-further-in-q4-royal-lepage/
Lanthier, N. (2024, July 23). Asset classes investors are betting on with commercial real estate in comeback mode. The Globe and Mail. https://www.theglobeandmail.com/business/industry-news/property-report/article-asset-classes-investors-are-betting-on-with-commercial-real-estate-in/
Nhieu, J., & Wong, R. (2024, October 22). Canadian CRE Investment Trends—Q3 2024 | Altus Group Insights. https://www.altusgroup.com/insights/canadian-cre-investment-trends/
Residential vs. Commercial Real Estate Laws in Ontario: Exploring the Key Differences | Royal York Property Management. (2024, April 15). https://royalyorkpropertymanagement.ca/news-article/residential-vs-commercial-real-estate-laws-in-ontario-exploring-the-key-differences
Understanding Real Estate Asset Classes and Property Types. (2024, February 11). https://www.yieldstreet.com/resources/article/understanding-real-estate-asset-classes-and-property-types/