When considering a potential commercial real estate investment, one of the most important inputs that an investor will consider is the deal’s potential rate of return. Fortunately, there are a number of widely used metrics that can help an investor assess whether or not a deal offers a suitable return given their own preferences.
In this article, we will describe the most common commercial real estate return metrics, how to calculate them, why they matter, and what “good” looks like. By the end of the article, readers will have the tools necessary to calculate and evaluate a potential investment’s returns.
At First National Realty Partners, we evaluate a potential investment on a number of return metrics and only present the most promising opportunities to our investors. To learn more about our current real estate investment opportunities, click here.
Commercial Real Estate Return on Investment Explained
The basic concept of a commercial real estate investment is a simple one. An investor exchanges an amount of money in the present for a potential stream of income in the future. If everything works as planned, the sum of the total income received will be greater than the amount invested, indicating a positive return. There are many ways to measure that return, and many angles to do it from. Below, we highlight four of the most common metrics used to measure commercial real estate investment success: cash on cash return, internal rate of return (IRR), capitalization rate (cap rate) and the equity multiple.
Cash on Cash Return
A property’s cash on cash return is the ratio of the cash received in any given year to the total cash invested. For example, suppose that an investor committed $10,000 in capital to an investment property and received $1,000 in dividends in the first year of the holding period. In this example, the cash on cash return in the first year would be 10% ($1,000 / $10,000).
As a general rule, a “good” cash on cash return is in the range of 6% – 10% annually.
Internal Rate of Return
When a real estate investor is presented with a potential opportunity, it is common to see the deal’s internal rate of return quoted as the potential return that can be earned. But, there can be some confusion about what this metric actually means.
By definition, a property’s internal rate of return is the discount rate that sets the net present value of its cash flows equal to zero. In other words, it is the compound annual rate of return earned for a given series of cash flows. The formula for calculating it is quite complex, instead it is easier to plug the property’s cash flows into a spreadsheet and use the “IRR” function.
As a general rule, an IRR of 15% – 20% is good, but real estate investors should not rely on this number alone because it does not provide a good view on an investment’s total return. For example, a $100 investment that returns $105 in one month has an IRR of 77%, but in reality the investor only earned $5.
An investment’s equity multiple is the ratio of total money received to total money invested. For example, if a real estate investor makes an initial investment of $10,000 and receives a total of $20,000, the equity multiple is 2.00X.
In a way, the equity multiple is the opposite of the internal rate of return in the sense that it provides a good view on an investment’s total return, but not how long it took to achieve it. In the example above, the $20,000 could be received in 1 year or 20 years and the equity multiple would still be 2.00X. For this reason, it should be reviewed in tandem with the IRR to determine whether or not an investment is a good one.
As a general rule, an equity multiple of greater than 2.00X is considered to be good.
Complications of Calculating ROI
The biggest complication in calculating the ROI metrics described above is that they are derived from estimated cash flows that are projected into the future. In other words, they have to be calculated at the beginning of the commercial property’s investment period and they are based on estimates of what will happen five or ten years into the future.
The actual ROI metrics are likely to be at least somewhat different than those projected at the beginning of the investment.
Return on Investment Does Not Mean Profit
Remember, ROI metrics are calculated at the beginning of the real estate investment holding period, based on cash flow estimates. While the metrics may be attractive, they do not equate to profit earned.
Actual profit can only be realized once the rental property is purchased and generating rental income. This income is used to pay for the property’s operating expenses (like property taxes, property management, debt service) and any money left over is distributed to investors. These distributions plus the gain on sale equal the realized profit on the property and could be different than original projections.
What is a Good Return on Investment?
For each of the real estate metrics described above, a general range is given for what is considered to be “good.” But, the truth is that each investor has their own risk tolerance, time horizon, and return objectives. So, what is considered to be “good” for one investor may not be good for another.
So, it is important to remember that a “good” return is somewhat subjective and should be considered relative to an investor’s preferences.
Commercial Real Estate ROI & Private Equity
Creating an accurate pro forma projection of a property’s income and expenses is a time consuming task that takes a significant amount of experience and expertise. It is not a skill set that all real estate investors have.
Fortunately, accredited investors have an option to partner with a private equity firm who creates a pro forma and performs all of the necessary ROI calculations on their behalf. Because this is what private equity firms do day in and day out, they have specific expertise in this type of analysis and can likely do a more thorough job than an investor is able to do on their own.
As part of their investment due diligence, private equity firms (ours included) look at an entire suite of performance metrics including those described above. In addition, they will look at other factors such as property value, closing costs, property type, real estate market, vacancy rates, mortgage payments, and potential net operating income (NOI). All of these factors combined contribute to the buy/don’t buy decision and investors can be assured that private equity firms take a data driven approach to analysis.
Summary & Conclusion
Fundamentally, a commercial real estate investor’s primary concern is the potential returns that they can earn on their investment.
Returns can be measured using a variety of metrics, including the internal rate of return, cash on cash return, and equity multiple.
But, ROI calculations should be taken with a grain of salt because they are calculated at the beginning of an investment’s holding period and are based on a property’s projected income.
Projected ROI is not the same as profit. Profit only happens once a property is purchased and actual income and profits are realized.
A “good” return on investment is somewhat subjective and is highly dependent upon an investor’s risk tolerance, return objectives, asset class (multifamily, office building, etc.) and individual preferences. One investor may consider an average return to be good while another may seek something higher.
When an individual partners with a private equity firm on a real estate transaction, the firm does all of the hard work of calculating ROI for potential investors. It may be a better task for them to perform since they have specific expertise, experience, and resources that may allow them to do a more thorough job.
The bottom line is that commercial real estate investors should always evaluate a property’s potential return before committing capital to it. However, ROI metrics should be taken with a grain of salt because they are often based on projections that may or may not be realized.
Interested in Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you would like to learn more about our commercial real estate investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.