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Return on Investment in Commercial Real Estate
In commercial real estate, return on investment (also known as ROI), is a measurement of how much money an investor receives from an investment after all expenses have been deducted. The formula for ROI is ROI = (Investment Gain - Investment Cost)/Cost of Investment.
- What is Return on Investment?
- What is the Cost Method for Calculating ROI?
- What is the Out-of-Pocket Method for Calculating ROI?
- ROI vs. Profit
- Other Ways of Determining ROI
- Other Factors Involved in ROI
- Questions? Fill out the form below to speak with a commercial real estate loan specialist.
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What is Return on Investment?
In commercial real estate, return on investment (also known as ROI), is a measurement of how much money an investor receives from an investment after all expenses have been deducted. The formula for ROI is:
ROI = (Investment Gain - Investment Cost)/Cost of Investment
Many factors affect the ROI of a commercial real estate investment, including the size of any commercial real estate loans on the property, the interest rate of those loans, as well as any management, repair, or renovation expenses needed to maintain or upgrade the property.
There are also many other formulas which help investors understand ROI, such as cap rates, cash on cash returns, and many more. Below we outline two of the most common ways to calculate ROI, the cost method and the out-of-pocket method.
What is the Cost Method for Calculating ROI?
To determine ROI using the cost method, we take the existing equity in a property and divide it by the costs of purchasing and owning that property. For example, if an investor purchased a property for $1 million, and invested $300,000 in renovations, and the property is now worth $2 million, the investor would have $700,000 of equity in the property ($2 million -($1 million + $300,000). As a result, we get an ROI of $700,000/$1,300,000 = 53.8%.
The cost method is a more simplified calculation, as it does not include the existing debt on the property. In this example, we have also not included any income that may have been received if the property was partially rented out during the rehab period.
What is the Out-of-Pocket Method for Calculating ROI?
Unlike the cost method, the out-of-pocket method incorporates the debt on the property into the calculation. So, if we use the same example above, and the property was acquired with a loan with 30% down, the initial cost would only be $300,000. Combined with another $300,000 in repair costs, the out-of-pocket costs for the property would be $600,000. Since the property is valued at $2 million, the investor would have $1,400,000 of equity. $1,400,000/$2 million = 70% ROI. This is a great example of how leverage can increase ROI significantly.
Once again, for simplification, neither the costs of the mortgage payments during the rehab period, nor any rental income that may have been received if the property was partially rented out during that time are included.
ROI vs. Profit
While calculating a property’s return on investment is great, it doesn’t show us how much profit the investor(s) will actually make. This is because the property needs to be sold in order for investors to realize any profits. In addition to the fact that a property may sell for well below its appraised value, selling a property may result in a variety of costs, including broker commissions as well as appraisal and marketing costs.
Other Ways of Determining ROI
In addition to using the out-of-pocket method and the cost method, there are a variety of other methods that investors use to calculate the return on investment for a commercial property. These include:
Cap rate: Net operating income (NOI) divided by a property’s market value
Cash-on-cash return: Annual dollar income divided by total dollars invested
Gross rent multiplier: Property price divided by gross rental income
What is the average return on investment for commercial real estate?
The average return on investment for commercial real estate varies greatly based on the specifics of an individual investment property. Generally, 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.
To determine ROI using the cost method, we take the existing equity in a property and divide it by the costs of purchasing and owning that property. For example, if an investor purchased a property for $1 million, and invested $300,000 in renovations, and the property is now worth $2 million, the investor would have $700,000 of equity in the property ($2 million -($1 million + $300,000). As a result, we get an ROI of $700,000/$1,300,000 = 53.8%.
For more information, please visit www.commercialrealestate.loans/commercial-real-estate-glossary/investment-variables and www.commercialrealestate.loans/commercial-real-estate-glossary/return-on-investment.
What factors affect the return on investment for commercial real estate?
The most important factor that affects the return on investment for commercial real estate is 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 factors include the safety of an investment property, a property’s development potential, the property’s location, and an individual investor’s financial instincts. Additionally, refinancing the property or taking out supplemental financing can complicate the ROI calculation for a property. If the owner has taken out an adjustable-rate mortgage, changes in the interest rate needs to be factored into the costs of property ownership.
What strategies can be used to maximize return on investment in commercial real estate?
There are several strategies that can be used to maximize return on investment in commercial real estate. These include:
- Doing thorough research and due diligence on potential investments
- Adding value to the property through renovations or other improvements
- Taking advantage of tax incentives and other financial benefits
- Developing a long-term investment strategy
- Working with experienced professionals to ensure the best possible outcome
For more information, please see the following sources:
What are the risks associated with investing in commercial real estate?
Commercial real estate is generally considered to be a higher-risk investment due to the potential for tenant default and the longer lease terms. Leasing velocity is much slower than in multifamily or single-family residential real estate, and so a vacant building may take longer to completely fill than a residential property.
Other risks associated with investing in commercial real estate include:
- Market fluctuations
- Interest rate changes
- Property taxes
- Insurance costs
- Maintenance costs
What are the tax implications of investing in commercial real estate?
Investing in commercial real estate can have a variety of tax implications. One of the most important things to do is to find a qualified tax professional who understands the field. Working with a professional can help you reduce your levels of stress and use some of the best strategies when it comes to taxes and your property.
When it comes to reducing taxes, there are a few helpful strategies. Wages paid to employees or independent contractors are tax deductible on Schedule E of the tax return. Additionally, any professional fees incurred, such as legal fees, property management fees, and accounting fees, are also tax deductible.
It is important to note that if you work with independent contractors and you pay them more than $600 in a single calendar year, you will have to send and file 1099s for them, since you qualify as a professional commercial real estate investor.
What are the best ways to finance a commercial real estate investment?
The best ways to finance a commercial real estate investment depend on your specific needs and financial situation. Generally, the most common ways to finance a commercial real estate investment are:
- Conventional Bank Loan: A conventional bank loan is a loan that is issued by a bank and is secured by the property. This type of loan typically requires a down payment of 20-30% and has a repayment period of 5-30 years. Interest rates are usually fixed and the loan is usually amortized over the life of the loan.
- SBA Loan: An SBA loan is a loan that is issued by the Small Business Administration and is backed by the government. This type of loan typically requires a down payment of 10-20% and has a repayment period of 5-25 years. Interest rates are usually fixed and the loan is usually amortized over the life of the loan.
- Private Money Loan: A private money loan is a loan that is issued by a private lender and is secured by the property. This type of loan typically requires a down payment of 10-30% and has a repayment period of 1-5 years. Interest rates are usually variable and the loan is usually interest-only.
- Hard Money Loan: A hard money loan is a loan that is issued by a private lender and is secured by the property. This type of loan typically requires a down payment of 10-30% and has a repayment period of 1-5 years. Interest rates are usually variable and the loan is usually interest-only.
It is important to research all of the available options to find the best financing option for your investment strategy. Our team is standing by to assist you in finding the absolute best loan for your investment needs. Fill in the form below, and we’ll get back to you with a free quote.
Other Factors Involved in ROI
There are other factors that can complicate the ROI calculation for a property, including whether the investors have refinanced the property, or if they have taken out supplemental financing. Overall, ROI calculations are generally somewhat more complex if the owner has taken out an adjustable-rate mortgage. This is because changes in the interest rate needs to be factored into the costs of property ownership.