What are the Most Important Investment Variables in Commercial Real Estate?
When it comes to making a decision on whether to invest in a commercial property, there are a number of variables that an investor can take into account. First and foremost is return on investment. This calculates the amount of money that an investor will make compared to the amount of money they’ve invested into the property, minus any expenses. Other variables include the safety of an investment property, a property’s development potential, the property’s location, and an individual investor’s financial instincts. In this post, we’ll review all of these in order to enhance your understanding of each.
Return on Investment
Return on investment, also known as ROI, is usually determined by using the formula below:
ROI= (Investment Gain - Investment Cost)/Cost of Investment
ROI can also be determined in a variety of other ways, including by looking at a property’s cash on cash returns, its cap rate, or even its gross rent multiplier (GRM). In general, most commercial investors prefer a cash on cash return of at least 12%, although this can vary based on the risk of an individual investment. Likewise, acceptable cap rates and gross rent multipliers also vary greatly based on the specifics of an individual investment property.
Safety of Investment
The safety of an investment is another huge factor in deciding whether purchasing a property is a good idea for an investor. There are a couple of factors to look at here, including an investor’s personal knowledge of the real estate in a particular area. For example, if you were to buy a commercial property in your neighborhood, where you’ve lived for years, it could be much safer than purchasing property in another state, where you are much less familiar with the market.
The riskier the investment, the higher rate of return you should expect. For instance, if you were purchasing a Class B or C office building in a somewhat run-down or up-and-coming area, you would want a significantly higher rate of return than you would for a premiere, Class A office building in an expensive metro area.
How much can you improve a building once you’ve purchased it? And how much will those improvements translate into an increased market value? If the answer is “a lot,” then your property may have a lot of development potential. If we take the example in the paragraph above, the premiere Class A building may not have much development potential, since it’s already a top-of-the-line property. However, a Class B office building might have a lot of room for improvement. For instance, if you were to purchase a building for $2 million and you estimated that with $400,000 in improvements, you could sell the property for $3.5 million, the property would have a significant amount of potential for development.
When buying a home, it’s common to hear that the three most important factors are “location, location, location.” That saying applies equally to commercial real estate. However, there are certain factors that may influence a property’s location-based value for certain buyers. For instance, if a buyer is a business owner who wants to use the property for their business, they may be willing to spend significantly more, as a property in a certain location could add a big boost to their business.
While ROI, cash-on-cash returns, development potential, and location can tell an investor a lot of the story, many experienced investors also rely on their gut feelings (as well as other market information) in order to make a decision on a property. Of course, because some investors have a much higher risk tolerance than others, a great investment for one individual, group, or company, could seem disastrously risky for another.