How to Evaluate Your Average Return in Commercial Real Estate Investing

A cornerstone of successful real estate investing, and ultimately a prosperous commercial real estate (CRE) portfolio, is achieving a robust return on investment (ROI). ROI serves as a key metric for evaluating profitability, making it a critical consideration for every investor, whether in stocks, bonds, or commercial real estate.

As an investor, having a clear understanding of the average return on your real estate investments over time is vital for making prudent property decisions.

In this guide, we will clarify the concept of average returns in real estate and outline several methods for calculating your average ROI. Additionally, we will offer guidance on identifying commercial properties with above-average returns.

Defining Average Return on Commercial Real Estate Investment

The average return on a commercial real estate investment is a key indicator that evaluates the profitability or loss of a property over time.

At its core, it quantifies the financial gain (or loss) from a real estate investment as a percentage of the initial investment amount.

For instance, if you acquire a property for $200,000 and generate $40,000 in income and appreciation, your average ROI would be 20%. While there are multiple ways to calculate ROI, some are more intricate, and this guide will cover several methods. These calculations are most effective when used in tandem.

The Importance of Average Return on Investment for Commercial Real Estate

Commercial real estate investments involve numerous variables that impact property value, including market conditions, tenant profiles, and other factors. Financing methods can vary, from full cash payments to leveraging mortgages.

Additionally, the revenue generated from a property is influenced by investment objectives, whether it’s a buy-and-hold strategy, leasing, or upgrading and selling. Calculating average ROI provides an objective measure for comparing opportunities and evaluating the profitability of investments.

It also enables investors to monitor the performance of their real estate portfolios, facilitating informed decisions on property acquisitions, holding, or divestment.

How to Calculate Average Return on Investment

Determining your average ROI in real estate involves several factors, such as purchase price, improvements, rental income, and property appreciation. Below are a few common methods:

Cost Method

This method calculates ROI by subtracting the cost of the investment from the total gain and dividing it by the investment cost.

Example: If a property was purchased for $200,000, with $50,000 spent on improvements, and was later sold for $350,000 after generating $50,000 in rental income, the ROI calculation would look like this:

Total Gain = Selling Price + Rental Income = $350,000 + $50,000 = $400,000

Total Cost = Purchase Price + Improvements = $200,000 + $50,000 = $250,000

Average ROI = (Total Gain - Total Cost) / Total Cost = ($400,000 - $250,000) / $250,000 = 60%

Out-of-Pocket Method

This approach accounts for financing by considering the down payment as the primary cost of the investment, thereby presenting a higher ROI when cash is borrowed.

Example: If a $25,000 down payment was made on a $200,000 property that was later sold for $350,000, the ROI would be:

Out-of-Pocket Expense = Down Payment + Improvements = $25,000 + $50,000 = $75,000

Investor’s Equity = Selling Price - Out-of-Pocket Expense = $350,000 - $75,000 = $275,000

Average ROI = Investor’s Equity / Resale Price = $275,000 / $350,000 = 78%

Rental Property Method

This method evaluates yearly profits, taking into account net operating income.

Example: For a property with a $25,000 down payment, generating $10,000 in rental income annually, with operating expenses of $2,500:

Net Operating Income = Annual Rental Income - Operating Expenses = $10,000 - $2,500 = $7,500

Average Yearly ROI = Net Operating Income / Out-of-Pocket Expense = $7,500 / $75,000 = 10%

Other ROI Calculation Methods

There are alternative approaches to calculating ROI, each offering different perspectives. Some include:

Cap Rate: Focuses on current property value and net operating income.

Cash-on-Cash Return: Evaluates the income generated relative to cash invested.

Internal Rate of Return (IRR): Factors in timeframes and compounding returns.

Equity Multiple: Measures the multiple of cash distributions relative to invested equity.

Nominal Return: A simplified view that does not account for factors like inflation or expenses.

Identifying Properties with Above-Average ROI

Achieving above-average returns requires a combination of acquiring properties at below-market prices and selling them at a premium. This process demands not only expertise in the commercial real estate market but also access to data-driven insights.

Modern tools, such as GIS analytics platforms, provide a competitive edge by offering precise data on location trends, demographics, and other factors. These technologies can help investors assess potential properties with greater accuracy and efficiency.

Conclusion

A solid understanding of your average return on investment is essential for making well-informed decisions and maximizing profitability in commercial real estate. Utilizing various ROI calculation methods, coupled with advanced tools like GIS platforms, can position investors to capitalize on high-yield opportunities and enhance portfolio performance.