In a typical commercial real estate investment, there are two sources of investor returns. The first, and usually largest is capital gains, which is the difference between the price paid for a property and the price it is sold for. While these gains can be significant, they usually take five to ten years to materialize. In the interim, investors receive periodic income, which makes up a smaller, but steady component of overall returns.
In this article, we will discuss a specific type of commercial real estate income known as residual income. We will describe what it is, how it works, and why it is important. By the end, readers will have a firm understanding of this concept and will be able to use it as part of their own real estate investment due diligence process.
At First National Realty Partners, we specialize in the purchase and management of grocery store anchored retail centers. Our investors like this property type because it tends to produce a steady stream of residual income over a long period of time. To learn more about our current investment opportunities, click here.
What Is Residual Income?
In a broad sense, the term residual income refers to income that is left over after expenses have been paid. To demonstrate this point, consider three specific scenarios where residual income may be realized.
In a personal context, residual income is the amount of money that a person has left over after their bills have been paid each month. For example, if an individual makes $5,000 per month in income and has $4,000 per month in expenses, their residual income is $1,000. This may also be called disposable income or excess income. High amounts of personal, residual income is closely correlated with financial freedom.
The same is true in a business context. If a company makes $1,000,000 in sales revenue and has $800,000 in expenses, the company has $200,000 in residual income. This may also be referred to as net profit or net income.
Commercial Real Estate (CRE)
Again, the concept is the same for a commercial real estate investment. To illustrate this point, consider the type of investment vehicles that we offer. With it, we purchase a grocery store anchored retail center, which produces a significant amount of rental income. We use that income to fund the property’s operating expenses like taxes, insurance, and maintenance.
Income, less these operating expenses equals a metric known as Net Operating Income (NOI). From this metric, the loan payments are made and any money left over is residual income that is distributed to our commercial real estate investors. These distributions produce a passive income stream, which is a major benefit of investing in a real estate deal.
Residual Income vs. Passive Income
Based on the description above, it is easy to think that residual income and passive income are the same thing. They aren’t, but the distinction is very slight.
Residual income is the metric that is calculated by subtracting an investment property’s operating expenses (including debt service) from rental income. This amount of money is then distributed to investors, which produces passive income for them. To demonstrate this point, consider an example.
Suppose that a multifamily apartment complex is purchased by two investors, who each own 50% of the rental property. It produces $100,000 in rental income and has $75,000 in operating expenses, including debt service. This leaves $25,000 in residual income, which is distributed to each investor in proportion to their share of ownership. So, each investor earns $12,500 in passive income.
As a real estate investment strategy, the pursuit of passive income is a common one. Fortunately, there are a number of investment options in which this can be accomplished. For example, real estate investment trusts (REITs), private equity, the stock market, bonds, mutual funds, and certain types of interest bearing checking accounts are all types of investments that earn passive income.
Residual Income in Commercial Real Estate
When evaluating a potential commercial real estate investment like an apartment complex, office space, or retail center, calculating residual income is one of the most important metrics because it informs how much passive income an investor can earn. For this reason, it is important for investors to complete due diligence on a passive investment’s potential. Key drivers of residual income in a commercial investment include:
- Property Value / Purchase Price: The purchase price impacts the amount of debt in the deal, which impacts the amount of debt service that must be paid, which ultimately impacts the amount of residual cash flow produced by the investment.
- Interest Rate: Again, the loan’s interest rate impacts the amount of required debt service, which impacts residual income.
- Property Type: Certain property types have more residual income than others. For example, an apartment building is likely to produce more residual income than residential real estate (like a single-family home) because of its size and scale.
- Real Estate Market: Commercial properties in strong, growing real estate markets tend to produce more residual income than those in stagnant or shrinking markets.
As described in the bullets above, the differences between types of real estate properties and deal structures can have a significant impact on residual income. This factor alone underscores the necessity of diversification in an individual investment portfolio.
Summary of Residual Income
The term residual income refers to the amount of money left over after expenses are paid. It can be used in several different contexts such as personal finance, business, and real estate.
In the commercial real estate asset class, there is a slight, but important, difference between residual income and passive income. Residual income is the amount of money left over after a property’s expenses have been paid. This amount of money is distributed to investors, which produces passive income for them.
In a commercial real estate specific context, there are a number of factors that can impact the amount of residual income produced by a commercial property. They include, property value, interest rate, property type, and real estate market.
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 email@example.com for more information.