Look at any financially-independent person’s portfolio, and you will probably see some commercial real estate (CRE) assets in it. CRE has long been a favored investment for those seeking to build stable, long-term wealth that can be passed on to the next generation.
If you’re interested in putting money in this asset class, it’s important to understand how to calculate the potential return you can get from your investment so you can decide if the property is truly worth buying.
You don’t need to be good at math to succeed in CRE investing, but having a working knowledge of basic concepts—including potential return on investment or ROI—is certainly essential.
What is Return-on-Investment?
In its simplest terms, ROI is the ratio between the cost of investment and net profit from it.
In other words, it’s how much profit is made on a property investment expressed as a percentage of that investment’s cost.
The higher the ROI, the better—it means that your investment dollars are efficiently and effectively used to generate profit. Many CRE investors (and investors in general) use the S&P 500 average returns as an ROI benchmark.
This is the basic formula for computing a CRE asset’s ROI:
ROI = Net Profit / Total Investment x100
Let’s use an example to illustrate how this formula is applied.
Let’s say that you flip commercial properties. You purchased a building at an auction for $750,000 and spent $350,000 in renovations.
Yours netted $1,600,000 from selling the renovated building after-sales, commission, and other expenses were paid.
Your net profit is what you netted ($1,600,000) minus everything you spent ($750,000 + $350,000), so it amounts to $500,000.
Your total investment is what you spent ($750,000 + $350,000), which totals to $1,100,000.
ROI = Net Profit / Total Investment x 100
ROI = 500,000 / 1,100,000 * 100
ROI = .45 * 100
Your ROI is 45%.
This is the basic formula and it is not always the right one to use. There are actually several ways to calculate commercial rental returns, and the ‘best’ way to do it really depends on what you want to figure out.
Let’s discuss three of the most common ways to calculate investment property returns:
We will also talk about when each of these methods is most useful.
What is CAP Rate?
This shows the CRE property’s net income in proportion to its market value. When computing the cap rate, the purchase price of the investment is usually used as its market value especially if the asset was acquired recently.
Read about more some of the important commercial real estate investment terminologies.
Let’s say you spent $1,000,000 to acquire a commercial rental property. It generates $120,000 each year in rental income. When you have paid for taxes, maintenance, insurance, and other operating expenses (not including mortgage payments), the net income is $80,000. Divide this by the cost of the property and you will get an 8% cap rate.
The cap rate can be extremely useful if you want an apples-to-apples’ method of comparing two or more potential investment properties with different financing structures because it does not account for debt repayment.
If a lender is asking for a 15% down payment on a 2-unit property and a 25% down payment for a 4-unit building, for example, you can use the expected cap rate to figure out which deal is better based on its rental income potential.
Cap rates are also widely used to evaluate commercial properties. If your property earns $80,000 per year in net income, you can use the cap rate formula to determine its approximate market value.
Cash-on-Cash Return
It is essentially the ratio between a property’s annual cash flow and its down payment. In other words, it shows the pre-tax cash inflows the investor receives from the property, and the pre-tax outflows the investor pays.
It’s not uncommon for CRE lenders to finance different properties differently. Reserve requirements and down payments can vary widely depending on how many units a property has, how old it is, and other factors.
One of the best ways to figure out which commercial property can produce the best profits for your money is to determine the cash-on-cash return. This is the metric to use if you are interested in several properties with different layouts and prices and want to figure out which one of them will produce the best cash flow.
The first property will generate a cash flow of $24,000 annually. Because you spent $250,000 to acquire it, its cash-on-cash return is 9.6%.
The second property cash flows $36,000 per year. You spent $450,000 to acquire it, translating toa cash-on-cash return of 8%.
In this case, the first property can be reasonably expected to generate more profit relative to how much money it costs to acquire it.
What is Total Return?
‘Total return’ refers to the combination of equity appreciation and income.
So far we have talked about cash-on-cash return and cap rate, which are both income metrics. But income is not the only way to make money from CRE. You can also profit from equity appreciation.
If you paid $1,000,000 in cash to buy a property and it generated a net income of $60,000 in one year and increases by $50,000 in value, your total return is $110,000or 11%.
‘Total return’ is usually used in CRE investing as a long-term metric—an evaluation of an asset’s performance after it is sold. Let’s take a look at the more complex application of this formula.
Let’s say you bought a $1,000,000 rental property with a mortgage, paying $250,000 out of pocket. You decide to sell it after 5 years. During the entire holding period, it produced a net rental income of $150,000. You sell it for $1,200,000, which is $200,000 more than its original purchase price.
In this case, your total return over five years is $350,000 or a whopping 1400% total 5-year return based on your investment of $250,000.
These three metrics can be extremely useful for different scenarios. The capitalization rate is great for assessing the market value of CRE properties. Cash-on-cash return is a good way to compare different properties, while the total return is very useful for assessing an asset’s performance (including equity appreciation).
There is no single ‘best’ metric—it all depends on what you want to find out. If you want to succeed in commercial real estate investing, then it’s important to master all of these so you can quickly and accurately analyze investment opportunities.
Now that you know how to determine the ROI of a commercial property, it’s important to understand the different financial factors that directly impact a property’s ROI so you can take them into account when assessing an investment’s real profitability. These factors are:
• Debt (loans or mortgages)
• Taxes and insurances
• Maintenance and rehabilitation costs
• Rental income
• Equity
Let’s take a look at each one.
You need to figure out the true total cost of your investment so you can accurately determine your property’s ROI. This is not a concern if you pay out-of-pocket whenever you purchase an asset, but most investors need financial assistance in this regard, in the form of loans and mortgages.
Any debt paid (or to be paid) over the course of the investment—be it a lump sum payment of a monthly mortgage payment—is one of the biggest financial costs of an investment property. It’s crucial to take them into account when calculating your ROI because these payments are subtracted from the property’s gross income to establish the net income.
Considerations need to be made for the amount the lender provided, the terms of the loan, and the interest rate when computing for the net income. Keeping an accurate record of these particular details can help you accurately calculate the true ROI of your investment property over time.
These factors are also crucial in determining a commercial asset’s ROI. Insurance and property taxes are alike in the sense that they vary depending on the type of property and the city/state where it is located. These expenses are also both determined by a third party—a property assessment organization or an insurance company.
If you’re a seasoned CRE investor, then you probably have your fair share of repairs and renovations. From minor things like fixing faulty plumbing to more involved repairs like completely rewiring a building’s electrical work, investors regularly have to deal with the headache of repairs—especially those who flip commercial properties to generate profits quickly. These repairs are often quite expensive. Depending on how much work is needed to bring a property up to scratch, this financial expense can be quite large.
Renovations are even more costly. They are typically used by CRE investors whose goal is to increase the value of an investment property and sell it at a much higher price than they paid for. Renovations encompass various expenses including all minor repairs and major rework for rehabilitating the property and increasing its market value.
On top of all these, plumbing and electrical systems need to be regularly inspected and maintained to ensure that the building’s amenities remain safe and functional. This is why maintenance and rehab costs are a big consideration when calculating an investment property’s ROI.
Commercial properties change in value as time goes by. Most real estate investors make it a goal to build equity in their properties as they pay off loans and as the property’s value increases over time.
Equity is obviously crucial; the higher it is, the more funds investors can use for future investments. It is a critical factor in determining an asset’s ROI.
Another method called the ‘cost method’ involves computing for a property’s ROI by taking the equity and dividing it by the property’s costs. Equity is determined by taking the market value and subtracting the total cost of the property from it.
Let’s say that commercial property was acquired for $3,000,000, for example. Repairs and renovations cost roughly $250,000, and they increased the property’s market value to $4,000,000. The total property cost is $3,250,000, so the equity $750,000.
The cost method is then used to calculate the ROI:
ROI = $750,000 (equity) ÷ $3,250,000 (cost) = 23%
Most commercial properties make money primarily from tenants. The number of tenants renting the property, how much you charge these tenants, and how often you charge them (annual or monthly) all affect your investment property’s income, which then affects its ROI. Maintaining an occupancy rate close to 100% is therefore critical to generating a better ROI and growing your profits.
As discussed in the first part of this blog, there are multiple ways to calculate an investment property’s ROI, and these are the main factors to consider to accurately determine it. Now let’s talk about some ways to increase the ROI on a commercial real estate asset.
ROI is undoubtedly the main driver of the investment decisions of people who buy commercial property. So how do you achieve a stronger ROI on an asset? It all comes down to spotting opportunities, finding a risk level you are comfortable with, and doing due diligence especially if you’re after capital preservation and security.
In an ideal world, a property can give you the ultimate combination of having high-profile tenants on long leases with favorable terms (such as tenants paying outgoings), plus fixed annual rental increases.
But it’s very hard to get all these in the real world. The good news is that even if a commercial property doesn’t exactly tick all these boxes, it can still potentially deliver better-than-average returns.
Perhaps you can find a property where the lease is due to expire. This will likely deter most investors. But if your research shows a solid probability that the tenants will renew their leases, then your gamble can pay off considerably.
It’s also important to look beyond the usual places. Commercial properties located in metropolitan areas tend to attract more investors, but those in regional areas can also yield strong ROIs. The key is to do your homework and truly understand the market you’re getting into.
Let’s take the example of regional bank branches. There are concerns about closures, so some investors stay away from them. But if you look closely, there are regional bank branches that are actually a prime investment because they cater to a big-enough catchment population that is isolated from the big competition, making them unlikely to close.
Well-located retail and medical premises in regional areas can also perform just as well as their counterparts in metropolitan areas—and they cost considerably less, so the yields are higher.
It’s also important to think about your choice of the asset. The market is constantly changing, with different types of CRE properties falling in and out of favor at different times. Having a cool head and enough courage to go against the norm can potentially help you get significant returns.
A good example is a childcare center. Investors used to be very concerned about these kinds of commercial properties years ago, but they became high in demand in recent years, with investor-friendly lease terms and strong lease covenants.
Similarly, gas stations went through a period of being unpopular. But now with major brands on well-regulated and modern sites, this property sector is commanding much higher prices.
Investors who can spot asset classes that other investors ignore but have the potential for solid performance can achieve above-average ROI. This approach is risky, of course, but the rewards are enormous.
Extended vacancies can lead to cash flow depletion, capital erosion, and reduced (even negated) ROI—not to mention a lot of stress. Improve your chances of avoiding vacancy by choosing a versatile type of property that is easy to release.
Retail properties are quite popular for this reason.
If a tenant leaves, it’s fairly easy to get a replacement and still achieve a good return, save for some inconvenience of onboarding a new tenant. It’s hard to go wrong with well-located supermarket properties. No wonder they are considered the ultimate “trophy investments” because they are always high in demand and there’s minimal risk of vacancy.
For investors who are more open to risk, industrial properties can potentially generate even higher returns, though they are harder to re-lease to new tenants.
Finally, don’t be afraid to seek access to commercial property intelligence that can help you make more profitable decisions. It’s a great way to find high-performing investments that you can add to your portfolio.
