In commercial real estate, just like any other investment, the primary reason that an individual or firm allocates money to an opportunity is because they think they can earn a return on their capital. However, to understand how much of return they stand to earn, there has to be a way to measure it.
In this article, we are going to describe the metrics used to measure returns in a commercial real estate investment and how they are calculated. By the end, investors will have the information needed to calculate these return metrics on their own as part of their own pre-investment due diligence process.
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What is Return on Investment?
Let’s start with the most basic concept, return on investment.
A return on investment is the profit that investors have earned or expect to earn as a result of allocating capital to an investment opportunity. In a very simple, safe example, an individual who places their money in a savings or money market account at a bank could expect to earn ~1% – 2% on their balances annually. For a $100,000 balance, they could expect to earn $1,000 – $2,000 per year in interest – this is their return on investment.
Depending on the industry or type of investment, there are a number of ways to measure return on investment. In this article, we are going to discuss those specific to commercial real estate.
ROI in Commercial Real Estate
In a commercial real estate context, there are three primary metrics used to measure investment returns, Internal Rate of Return (IRR), Equity Multiple, and Cash on Cash Return.
The Internal Rate of Return is a measure of the return on the amount of money invested for each period of time it is invested in. The formulas used to calculate it can be complex – in reality the easiest way to calculate it is to use the “IRR” function in any common spreadsheet program. Typically, investors aim for an IRR in the 12%+ range annually.
Equity multiple is a measure of the total returns received relative to the total amount of money invested. It is calculated as total cash received by total cash invested and investors typically shoot for an equity multiple of 2.0X+. For example, if an investor received $200 from a $100 investment, the equity multiple would be 2.0X.
Cash on cash return is the ratio of cash received annually to the amount of the original investment. For example, if an investor received $5 in the first year of a $100 investment, the cash on cash return would be 5%.
These metrics are calculated from a series of income and expense projections contained in a proforma, which is calculated prior to making a purchase or property investment.
What Impacts Real Estate ROI?
Think of a commercial real estate investment property like a small business. The revenue comes from rental income and the operating expenses come from the costs required to run the property – like property taxes, insurance, maintenance, and property management. The difference between income and operating expenses is a figure known as Net Operating Income – NOI for short – which is a key figure because investors can apply a capitalization rate (cap rate) to determine market value.
From net operating income, debt service is subtracted and the funds available to distribute are left over.
With this in mind, there are several factors that impact ROI, but the most important include:
- Rental Rates: Rental rates drive top line income for a property. Any change in them, up or down, will have a material impact on ROI.
- Vacancy: The occupancy level of the property also has an impact on ROI because it also drives rental income. For example, a property that is 85% full produces a lot more income than one that is 50% full.
- Operating Expenses: On the expense side of the equation, the amount of operating expenses has a major impact on ROI. Properties that have high expense levels will produce less ROI than ones that are run very efficiently.
- Debt Service: The commercial mortgage payments on a property dictate how much money is left over to distribute to investors. Properties that have a low interest rate loan and low debt service tend to produce higher annual returns than one that is highly leveraged with high interest rate debt.
- Deal Structure: Most commercial real estate deals have two classes of investors, general partners and limited partners. The split between the two will have a major impact on the amount of money that is ultimately available to distribute to investors.
There are a number of other factors such as closing costs, purchase price, sales price, and down payment/total investment that can impact the cash flow and returns a property investment generates. All of these factors are addressed in the property proforma/financial model and can help investors predict what the potential return on investment may be.
How To Calculate ROI on CRE Investment
The very first step to calculate ROI is to create a proforma projection of income and expenses over a planned holding period. While this may seem simple, it can actually be a very complex task because it requires a significant amount of analysis and a data driven set of assumptions. The proforma will not be exact, but it needs to be directionally accurate to make the necessary ROI calculations.
Once the proforma is complete, the three metrics described above can be calculated as follows:
- IRR: Use the IRR function in a spreadsheet with the initial investment and the annual cash flows after debt service. Again, a general target for a good NOI is >~12% annually.
- Equity Multiple: Total cash received in all holding periods divided by the initial investment. The target is >2.0X.
- Cash on Cash Return: Annual cash received, net of debt service, divided by the amount of the initial investment. The target is >5%.
While these metrics are the industry standard, they aren’t the only ones used to calculate a property’s ROI. There are other, more simplistic measures described below.
Cost Method vs. Out of Pocket Method
Cost Method
The cost method for calculating ROI on a potential investment uses the existing equity in the property and divides it by the cost of purchasing and owning the property.
For example, suppose a real estate investor purchased a property for $1,000,000 and invested $250,000 in renovations. Once complete, the property is worth $1,750,000, which means that the investor has $500,000 equity in the property.
So, in this case, the real estate investor’s total ROI is $500,000 divided by their total cost of $1,250,000 or 40%.
This may be an overly simplistic calculation and does not account for the amount of time that it took to complete renovations and improve property value. If it took one year, this would be a good investment. If it took 10 years, it doesn’t seem as exciting.
Out-of-Pocket Method
The out-of-pocket method for calculating ROI incorporates any debt that is placed on the property. Or, put another way, it only looks at the money that a real estate investor actually takes out of their pocket for the property.
Using the same example above, suppose the investor purchased the same property for $1,000,000, but used 70% debt to finance the purchase ($700,000) – meaning they put $300,000 of their own money into the deal. If this down payment is combined with the $250,000 in renovation costs, the total out-of-pocket expense is $550,000. If the property’s post-renovation market value is $1,750,000, the investor now has $1,200,000 in equity in the property. Thus, their ROI is $1,200,000 / $1,750,000 or ~68%. The boost comes from the addition of debt, which reduces the initial cost of the investment for the investor.
It should be noted that the out-of-pocket method may also be an overly simplistic calculation because it does not account for: (1) the time it takes to complete renovations; (2) the mortgage payments that must be made during this time; or (3) any rental income earned during the renovation period.
The Importance of Understanding ROI as a Real Estate Investor
As a real estate investor evaluating potential investment opportunities, understanding ROI is critically important for two reasons.
First, it provides a gauge for the return that can be expected on an investment. Although, it should be noted that ROI is first calculated during the pre-investment due diligence stage and the actual ROI may turn out to be more or less depending on real estate market conditions over the term of the investment.
Second, it provides a basis for comparing one investment opportunity to another. For example, if an investor is looking at 3 potential deals, the logical choice would be the one that offers the highest ROI.
What Can Reduce ROI
Actual ROI can be less than proforma ROI if the money returned to investors is less than what was planned for on the proforma.
There are a number of factors that can cause this to happen including lower rental income, higher vacancy, higher operational expenses, and an unexpectedly large capital improvement expense (like replacing a roof). Any of these items can reduce the pre-tax cash flow sent to investors and cause the actual ROI to be lower than planned.
How Do Taxes Affect ROI?
ROI is typically calculated on a pre-tax basis because most commercial property investments are made through a limited liability company, which is a pass-through entity for tax purposes.
Taxes can absolutely affect ROI, but they impact each individual investor differently because everyone’s financial situation is unique. So, each investor should calculate their own after tax ROI to see if it meets their own objectives.
Taxes When Selling
The impact of taxes is not just felt on an annual basis. Successful commercial real estate investments typically experience some sort of windfall upon the sale of the property, which is taxed differently than the dividend income received each year. For tax purposes, a profit upon sale is classified as a “gain,” and the tax rate depends on the individual’s tax bracket and the length of time a property was held.
So, once again, investors should factor this into their personal return when trying to calculate NOI.
So, What is a Good ROI?
Every investor’s perception of a “good” ROI may differ, but most commercial investments target a minimum annual return of 12% – 15% annually as measured by IRR. Remember, this is a pre-tax figure so the after tax number will be less.
But, each individual investor should take stock of their own needs and expectations and use those to determine what a good ROI is for themselves.
ROI on Private Equity Real Estate Investments
For individual investors, the pre-investment due diligence process can be intimidating. There is a lot of data to collect and the process of building a financial model and calculating return metrics can be tricky. For this reason, many investors may prefer to partner with a private equity firm to perform these difficult tasks on their behalf.
In a typical scenario, the private equity firm does all of the hard work of finding, financing, and analyzing potential investment opportunities to ensure they meet a base level threshold for returns and quality. They also do all of the hard work of managing the property once the purchase is complete. For individual investors, this takes much of the due diligence work out of the equation and provides a source of passive income that will drive investment returns.
Summary of Return on Investment in Real Estate
In any sort of investment, the only reason that an investor would commit capital to an opportunity is because they anticipate that they will receive a return.
In a commercial real estate context, the return on investment (ROI) is measured using metrics like the Internal Rate of Return (IRR), Equity Multiple, or the cash on cash return.
These metrics are driven by key elements of the property including things like monthly rent, maintenance costs, vacancy, and interest rates. Because markets are dynamic, these factors may change over time, causing the average return to go up or down in response.
A “good” ROI is somewhat dependent upon the property type and the return objectives of the real estate investor, but a general rule is that 12% – 15% annually is a good ROI for a rental property.
There is a lot of upfront work that goes into finding and analyzing potential investment properties. For some individual investors, it may be overwhelming. In these scenarios, it may be a compelling option to partner with a private equity firm to generate a good ROI on a commercial real estate investment.
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 are an Accredited Real Estate Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
