One of the building blocks of successful real estate investing, and ultimately a thriving commercial real estate portfolio, is a healthy return on investment. Return on investment (ROI) is an indicator of your profitability, so it’s understandably something every investor is interested in, whether it be stocks, bonds, or commercial real estate.
As an investor, it’s essential that you understand your average return on your real estate investment over time, so that you can ensure you are making wise decisions regarding your property.
In this guide, we’ll explain what average returns mean in real estate investing and walk you through some different methods for measuring your average ROI. We’ll also provide tips for finding commercial properties with above-average returns.
What is Average Return on Commercial Real Estate Investment?
Average return on investment is a metric used to assess the profit/loss of a real estate asset over time.
In its simplest form, it measures the amount of money earned (or lost) on a property investment as a percentage of the total amount spent on it.
For example, if you acquired a property for $200,000 and earned $40,000 in rental income and appreciation to date, your average return on investment would be 20%. There are numerous different ways of calculating average return on investment.
Some are more complex than others, and we’ll cover several in this guide. Generally, they are most effective when used together.
Why Average Return on Investment is Important for Commercial FReal Estate
Investing in commercial real estate involves considering a multitude of variables. Property itself is a physical thing that requires maintenance over time. The value of a property changes depending on the market, tenants, and multiple other factors.
Financing a property and its ongoing costs can be done multiple ways, from paying cash to leveraging a mortgage.
Furthermore, revenue generated from a commercial property depends a lot on your investment goals, such as whether you’re buying a property to lease it out, or you’re planning to upgrade and sell it.
Calculating your average return on investment offers an unbiased approach for comparing investment opportunities and evaluating which ones yield the highest returns.
Additionally, average ROI can help you track the performance of a commercial real estate portfolio and make solid decisions regarding buying, holding, or selling properties.
How to Calculate Average Return on Investment
Calculating your average return on investment for real estate involves several factors, including the initial purchase price, the cost of improvements, rental income, and appreciation. Here are some commonly used methods for calculating average ROI:
1. The Cost Method
To calculate average return on investment using the cost method, take the monetary gain on the investment (for example selling price) less the cost of the investment (for example the purchase price and maintenance) and then divide that by the cost of the investment.
Average return on commercial real estate investment is calculated using the following formula:
Gain on Investment can include:
- Selling price
- Rental income
Cost of Investment can include:
- Purchase price
- Transaction costs
- Ongoing repairs and maintenance
- Costs of property upgrades
- Taxes
- Other ancillary expenditures
Example Calculation: The Cost Method
Let's say you purchased a property for $200,000 and spent $50,000 on improvements and maintenance. You rented the property out for five years, earning $50,000 in rental income. After five years, you sold the property for $350,000. Here's how to calculate your average return on investment:
Total Gain = Selling Price + Rental Income
= $350,000 + $50,000
= $400,000
Total Cost = Purchase Price + Improvements + Maintenance
= $200,000 + $50,000
= $250,000
Average ROI = (Total Gain - Total Cost) / Total Cost
= ($400,000 - $250,000) / $250,000
= 60%
2. The Out-of-Pocket Method
The out-of-pocket method for calculating return on investment gives a view of profitability taking into account the amount of cash leveraged through a mortgage or loan. Instead of using the full purchase price as part of your cost of investment calculation, you would use the cost of the down payment.
Because money can be borrowed to finance a property, your initial cash investment is effectively lower, which means your return-on-investment percentage will be higher.
This method is often preferred by real estate investors because it shows a higher and perhaps more accurate return on the actual cash invested.
Average return on commercial real estate investment is calculated using the following formula:
Out-of-pocket expense is made up of the cost of the investment and can include:
- The down payment cost
- The costs of upgrades and expenses associated with keeping the property
The investor’s equity is calculated by subtracting the out-of-pocket expense from the selling price.
Example Calculation: The Out-of-Pocket Method
Take the example above, but instead of paying $200 000 cash, you take out a loan to buy the property, with a down payment of $25 000. A few years later you sell the property for the same $350 000.
Out-of-pocket Expense = Down Payment + Improvements
= $25 000 + $50 000
= $75 000
Investor’s Equity = Selling Price - Out-of-Pocket Expenses
= $350 000 - $75 000
= $275 000
Average ROI = Investor’s Equity / Resale Price
= $275 000 / $350 000
= 78%
3. Rental Properties
When renting out a property, you’ll be more interested in what your average yearly profits are. To calculate this ROI, you can use a formula that takes this into account:
Example Calculation: Rental Properties
Take the example above, where you paid a $25 000 down payment on a loan. You earned $50 000 in rental income over 5 years, so let’s say you earned $10 000 rental per year on average. Subtract operating expenses of $2500 which gives you a net operating income of $7500.
Out-of-pocket Expense = Down Payment + Improvements
= $25 000 + $50 000
= $75 000
Net Operating Income = Annual Rental Income – Operating Expenses
= $10 000 - $2500
= $7 500
Average Yearly ROI = Net Operating Income / Total Out-of-Pocket Expenses
= $7 500 / $75 000
= 10%
Alternative Methods for Calculating ROI
There are several alternative ways to calculate the return on your real estate investment, each of which offers a different perspective, and takes different (or extra) factors into account. It’s important to use these calculations together to gain a balanced perspective of your investment or portfolio. Here are a few to consider:
Cap Rate
The Cap Rate, or Capitalization Rate, is a calculation to determine the expected rate of return on an investment property.
It’s calculated by dividing a property’s net operating income by the current market value, so will give you a more current and operationally-focused view.
Cash-on-Cash Return
Cash-on-cash return is a measure of the income earned on the cash invested in a commercial real estate deal. It looks specifically at the cash invested and includes allowance for debt and/or mortgage costs.
In this way, it’s similar to the out-of-pocket ROI calculation, although it takes into account the investment returns up to a specific point in time.
Internal Rate of Return
The internal rate of return is a lot like return on investment, as it’s a calculation of the value a property generates during the time frame that you own it.
However, it goes a lot deeper and takes timeframe into account. It also accounts for more granular aspects of returns, such as interest earned on rental income, which would compound over time.
Equity Multiple
For real estate investments, the equity multiple is calculated by dividing the total cash distributions received from an investment by the total equity invested.
This metric illustrates the amount of money an investor can potentially earn, represented as a multiple, such as 1x or 10x.
Nominal Return
The nominal rate of return is the return generated by an investment without adjusting for any negative factors like inflation, taxes, or other expenses. It’s a very high-level indicator of ROI that doesn’t take expenses into account.
How to Find Properties with Above-Average ROI
Attaining an above-average return on investment is every commercial real estate investor’s goal. You can achieve this either by having a higher gain (such as, selling at a high price), or a lower cost of investment than the average competitor in your market (such as, buying at a low price).
Realizing this can be quite complex. It requires an understanding of more than just the calculations involved, but also an in-depth knowledge of the CRE industry with access to detailed market data and trends.
Thankfully, modern technologies like property intelligence platforms and GIS analytics tools can do a lot of the hard work for you, giving you the edge when it comes to identifying the most promising properties, and managing them smartly to optimize returns.
A GIS analytics tool will give you access to data on location trends, traffic flows, demographics and much more. Using powerful algorithms coupled with accurate spatial information, it’s possible to identify and compare potential investment properties, and plan potential income and costs on investments with more accuracy than ever. And fast!
Final Thoughts on Average Return on Commercial Real Estate Investment
Understanding your average return on investment is crucial to making well-informed decisions, optimizing your portfolio, and ensuring long-term success in the ever-evolving commercial real estate industry.
By employing various methods to calculate average ROI, such as the cost method, out-of-pocket method, and rental property calculations, you can gain a comprehensive and nuanced perspective of your property's performance.
Staying up-to-date with industry trends and utilizing the latest CRE technologies will also help you get ahead. A GIS analytics platform can help identify and capitalize on above-average ROI opportunities.
As you continue to grow your real estate portfolio, remember to consistently evaluate your investments, adapt your strategies, and be proactive in seeking out the best opportunities to maximize your returns.
