What is 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 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
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.