If you’re looking to invest in commercial real estate, it’s essential to determine the return on investment (ROI) before investing. It’s measured by three metrics: equity multiple, cash-on-cash return, and the internal rate of return. But how do investors determine what a good ROI is for commercial real estate?
A good ROI for commercial real estate is between 12% and 15% annually. There is no set figure that is a good ROI for commercial property because too many variables affect this figure, including the amount of risk the investor is willing to take. But it’s good to aim for 12% – 15%.
Commercial real estate generally has a better ROI compared to residential properties. Many investors are attracted to the income potential of commercial property. They can charge more, offer longer leases, and don’t have to struggle to find tenants. However, understanding the ROI is crucial in choosing which property to purchase.
What Is A Good ROI For Commercial Real Estate?
Determining a good return on your real estate investment is challenging because no set figure defines a good return. Many investors may consider 8% -11% acceptable, while others prefer to aim for 12% – 15%.
The level of risk an investor is willing to take significantly impacts the ROI. The bigger the risks, the more likely you’ll see a better return. In some cases, some people prefer to take fewer risks, and while their profit could be higher, they are still satisfied.
What Factors Affect A Good ROI?
Numerous factors affect the amount generated from your property. Some of these include the type of building, location, market fluctuations, and financing terms. It’s also vital to consider your investment plan when determining profits; anything under the market value is not considered a good return on your investment.
How To Increase The ROI In Commercial Real Estate?
Despite there being many variables influencing your ROI, there are a few ways you can increase your profits. These include:
- Research the building you want to purchase thoroughly and ensure it’s feasible.
- Use an investment strategy. Consider your long-term and short-term goals.
- Take advantage of tax benefits.
- Work with real estate companies and other professionals with commercial property experience.
- Look at buying more affordable properties.
- Increase the value of the investment by doing renovations.
- Look at areas where you can reduce costs.
What Commercial Property Offers The Best ROI?
Multifamily buildings are a good choice if you’re looking to invest in commercial real estate. These include buildings like complexes and apartments and are excellent as a first investment for beginners. Properties that can take many tenants also offer great earning potential.
Buildings in high-traffic areas or in locations with schools, malls, and stores are also a good investment. You can also aim for triple net leases, where a single tenant occupies the entire space and signs a long-term lease, which is less risky than other types of commercial spaces.
How To Calculate ROI In Commercial Real Estate?
Calculating ROI in commercial real estate is tricky, and investors use many formulas to work this out. Two of the most widely used are the cost and out-of-pocket methods. Still, these only evaluate the average return on the investment and don’t consider loans, interest rates, property tax, and utilities.
The Cost Method
The cost method [A1] is calculated by dividing the equity by the costs of renovations on the property. The profit or gains in this method may include rental income or the selling price of a building. Costs related to the investment include taxes, renovations, and maintenance.
For example, if a business owner purchased a property for $500,000 and invested $50,000 in upgrades and renovations. After the renovations, the property has a market value of $700,000. This means your gain after adding the purchase price and the renovations together is $150,000.
Gain $150,000 / total invested $550,000 = 27%
27% ROI
The Out Of Pocket Method
The out-of-pocket method is preferred because it yields a higher ROI. It calculates the return based on what was invested into the property. This method also considers any loans used to finance the purchase and down payments.
Using the same example, let’s say you purchased the building for $500,000 but used a loan and put a downpayment of $300,000. You then decided to renovate, which cost you $90,000 plus the down payment of $300,000, totaling $390,000.
The property is valued at $700,000. Subtract the amount invested, which is $390,000, and you’ll get your potential profit.
Amount invested $390,000 / Property value $700,000 = 55%
55% ROI
What Other Methods Are Used To Calculate ROI?
It’s essential to use several methods to calculate a property’s earning potential. While working out the ROI based on the cost and the out-of-pocket method is excellent for indicating earning potential, there are other methods you should consider. These include:
- Internal Rate Of Return. The internal rate of return is the amount of money a building generates while you own it.
- Equity multiple. The equity multiple is the potential a building can earn, which is represented by a multiple, like 10x. It calculates the total equity invested and the total cash distributed over a specific period.
- Gross Rate Multiplier. The gross rate multiplier is the price of the property divided by the rental income. Investors use this method with the cap rate to determine the earning potential of apartments, malls, and complexes.
- Cap Rate. Cap rates help evaluate properties and are calculated by taking the net income of a commercial building and dividing it by the current market value.
Conclusion
Determining a good ROI on commercial real estate is challenging because many factors influence an excellent return. Investors should aim for a 12% or 15% return and nothing less than 8%. No set figure determines a good ROI, so investors should implement a long-term strategy to get the most out of their commercial property purchases.