Like many sectors, commercial real estate (CRE) has its share of jargon and acronyms. These sometimes confuse even the most experienced CRE professionals.
They are important though, as many of them relate to types of commercial real estate calculations you might use while doing a due diligence on a potential CRE deal.
Mistaking one for the other could mean the difference between buying a profitable investment or making a costly mistake.
So how can you navigate the terms quickly and sound like the smartest person at the next CRE cocktail party?
1. Price Per Square Foot
Price per square foot is a way of measuring the value of a commercial property based on the area of the floor space.
It’s used as a standard method for comparing one property to another based on size.
When to use this metric:
- To directly compare properties in similar locations, with similar characteristics, and within the same property type
- To identify overpriced or underpriced properties
- In property valuations and appraisals
- As a negotiation and pricing strategy tool
- To evaluate the potential return on investment of a property deal
Price Per Square Foot = Property Price / Floor Space (ft²)
Note for international readers: 1 ft² = approximately 0.0929 m2.
2. Return on Investment (ROI)
Return on investment (ROI) is a commercial real estate calculation used to measure the amount of profit (or loss) generated on a CRE asset over time.
While looking back at profit generated is helpful, CRE professionals usually want to assess a property’s profit-making potential by predicting the ROI in advance, before making a commitment to a deal. This is where this calculation comes in handy.
While simple in principle, there are a few metrics which calculate return on investment, each slightly differently. Two common ways include the ‘cost method’ and the ‘out-of-pocket’ method. We’ll cover a few more methods in the rest of this guide.
To calculate ROI using the cost method, take the money gained on the investment (for example selling price) minus the cost of the investment (for example the initial purchase price and maintenance expenses) and then divide that by the total cost of the investment.
The cost method formula is:
ROI = (Total Gain - Total Cost) / Total Cost
To calculate ROI using the out-of-pocket method use the cost of the downpayment for your mortgage, divided by the market value price of the property.
The out-of-pocket method formula is:
ROI = Investor’s Equity / Resale Price
3. Cash-on-Cash Return
Cash-on-cash return measures how much profit you make based on the total cash you invest in a CRE deal. Also known as the ‘cash yield’, it’s a useful metric because it shows you how hard your money is working for you, and it takes the debt or mortgage fees into account.
Instead of looking at the market value of the property (like some of the other ROI calculations), or even the total purchase price of the property, you’re looking at the initial amount, or cash deposit, the investor has put into the deal excluding the mortgage loan.
Then add any additional money spent on additions and improvements to the property over time (if you paid for them out of your own pocket). To calculate the cash-on-cash return you take the annual before-tax cash flow of the property and divide it by this cash investment amount.
Cash-on-Cash Return = Annual Before Tax Cash Flow/Total Cash Invested To-Date
4. Nominal Rate of Return
Nominal rate of return is a way of calculating the increase or decrease in value of a property over time, as a percentage of the original investment value. It doesn’t take any adverse factors like inflation, taxes, or other property expenses into account.
Use nominal return to get a high-level overview of the profitability of the CRE assets in your portfolio.
Nominal Rate of Return = (Current Market Value – Original Investment Value) / Original Investment Value
5. Net Operating Income (NOI)
Net operating income (NOI) is useful because it measures the actual income you are making on a property. Thus, it’s a measure of profit. You can calculate NOI by subtracting the property’s operational expenses (management fees, basic repairs, and insurances) from the revenue generated (rental income).
Net Operating Income = Annual Gross Revenue - Operating Expenses
6. Gross Rent Multiplier (GRM)
If you’re looking for a quick snapshot of the potential investment return on an income-producing commercial property, gross rent multiplier (GRM) is the metric you need.
Essentially, GRM shows you how many years it would take to earn your money back, based on the yearly rental income.
To calculate GRM, divide the property price by the annual gross rental income. Note that it does not take operating costs and maintenance expenses into account.
Gross Rent Multiplier = Market Value of Property / Annual Gross Rental Income
7. Cap Rate (Capitalization Rate)
Cap rate is a term you’re going to come across sooner rather than later. It’s short for ‘capitalization rate’ and is an alternative method for calculating ROI. Unlike GRM which excludes the maintenance and operating costs, and property taxes, cap rate takes these into account.
It does this by using the net operating income instead of the gross income. It’s clear that cap rate might yield more specific insights than GRM, depending on your approach to a property deal.
Capitalization Rate = Market Value of Property / Net Operating Income
8. Loan-to-Value Ratio (LTV)
Loan to value (LTV) is a ratio typically used to communicate the percentage of a property’s market value lenders are willing to finance. A common LTV ration is 75% which means that an investor can borrow three quarters of the total cost of the property. You’ll need to finance the remaining 25% out of your own pocket.
LTVs tend to vary based on the risk associated with a borrower. A high-risk borrower (such as a first-time investor) will be able to borrow less from the lender than a seasoned CRE professional who is going in on their 10th deal. LTV is relevant both at property acquisition stage, and also when refinancing.
Say the first-time investor got a 60% LTV on their property initially but they refinanced a year later for 75% LTV, the result is less cash left in the deal, and therefore more cash freed up to expand the portfolio.
Loan to Value = Mortgage Amount / Property Market Value x 100
9. Equity Multiple
Equity multiple refers to the amount of return generated per dollar of cash spent over a specific holding period, and it usually includes the sale price of the property. Use equity multiple to calculate how much your initial equity contribution has grown over the period you held it for.
Calculate the total cash ‘inflows’ during the period you owned the property – add up all the annual before-tax cash flows for each year. Add the sale price of the property. Then, divide this amount by the initial cash injection you made on acquisition – usually the purchase price.
Equity Multiple = Total Cash Distributions / Total Equity Invested
10. Return on Assets (ROA)
Return on assets (ROA) differs from ROI in that it considers the profit generated from the total value of the assets. It can be used as a measure of the property’s efficiency as it shows you how much profit each dollar of your property’s value generates for you. ROI on the other hand measures your profit based on your initial spend.
Calculate ROA by dividing a property’s annual net income by the value of all its assets, which could include the property, equipment and machinery, and any upgrades or improvements.
Return on Assets = Net Operating Income / Total Assets
Final Thoughts on Navigating Commercial Real Estate Calculations
Commercial property deals are often multifaceted, requiring a deep understanding of the various metrics and calculations. While there are many more, the calculations in our list cover some of the key types of metrics you need to know to make sense of investment returns in relation to property size, market dynamics, and rental yields.
So, the next time you find yourself evaluating a CRE opportunity, let them serve as your roadmap to a more informed and profitable decision.
