ROI on commercial real estate
What is the return on investment? Return on investment (ROI) is a measurement of how much money or profit is made on investment as a percentage of its cost. Since this metric shows how well your investment dollars are being used, it pays to know both what ROI is and how to calculate ROI in real estate. Here are some things you might want to know on ROI on commercial real estate
There is a large variety of ways to invest. But the most successfully proven way of gaining high returns has been through commercial real estate. This is not just a recent phenomenon. This dates all the way back to the founding of the United States. John Jacob Astor became America’s first millionaire through commercial real estate in Manhattan. And the fundamental reasons that commercial real estate is the #1 investment choice remain as true today as they were in the 1800s.
Return on investment (ROI) shows how effectively and efficiently investment dollars are used to generate profits.
Many investors use the average returns on the S&P 500 as the benchmark for a target return on investment (ROI).
Return on investment (ROI) is an accounting term that indicates the percentage of invested money that is recouped after deducting associated costs. For the non-accountant, this may sound confusing, but the formula may be simply stated.
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 is 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.
Drawbacks Of ROI
While the simplicity of the cash on cash return is a benefit, it’s also a drawback. The ROI only gives you a measurement of return based on the initial investment you made into the property at a specific point and time.
Your time value of money isn’t taken into account, which isn’t too important for some investors, and it also doesn’t measure your return based on your built-up equity in the property.
Positives of ROI
One of the hallmarks of commercial real estate is that they are income producing. Unlike most stocks, which pay no dividends, commercial real estate is defined by its ability to pay out regular cash distributions. This is an extremely important trait, as it allows the investor the ability to have greater patience through recessions – since they don’t rely on the sale of the asset for income – as well as give greater security in covering problems that may come up along the way. With most stocks, the only way to realize any income is to sell the stock.
With commercial real estate, income is achieved from the cash-flow of the property, regardless of a sale. In addition, commercial real estate has traditionally had the highest returns of any form of investment. While most stocks that do pay dividends are lucky to hit 3% distributions annually, and CDs, Treasuries, and bonds paying as little as 1%, it is not uncommon for commercial real estate to pay out 10%+.
Most commercial real estate is based on pretty basic needs. Such as shelter (apartments and mobile home parks), basic services (retail and office), and storage (self-storage and industrial warehouse). While stocks often revolve around fairly complex business models that are often built on luxuries. Commercial real estate is based on strong, perpetual demand. In addition, while stocks trade at price-to-earnings ratios (also known as P/E ratios) of up to 100 or more, commercial real estate rarely trades for P/E ratios of 10 or less – and the lower the P/E number, the lower the risk.
Most commercial properties have multiple tenants. This gives the owner some portfolio balance and diversity – they are not 100% reliant on just one tenant’s rent. For example, if you have a 100-space mobile home park, and one tenant leaves. The impact on the property’s finances is minimal. However, with a stock or bond, you are 100% tied to one business. And if it fails or does poorly, your investment is ruined.
On Point Partners
On Pointe Partners is a Global Real Estate Consulting Firm that is committed to crafting innovative and creative strategies that are rooted in our mission to transform communities through real estate. These projects promote economic growth. No matter the location or the community we influence positive change that produces measurable results worldwide.