What is a Good Return in Commercial Real Estate?
Consider these factors before you make a new investment.
When learning about a new real estate opportunity, one of your first questions is probably, “What’s the projected ROI?” But how do you determine whether an ROI is high enough?
Unfortunately, like most questions in real estate, the answer to this is not cut and dry. Commercial real estate returns vary depending on a wide variety of factors, and a “good” ROI for one property might not be “good” for another.
Here are some of the important things to consider when evaluating the expected ROI of a new real estate investment.
How is ROI Calculated?
Put simply, ROI is the expected returns from the investment minus the cost of the investment, divided by the cost of the investment.
To calculate your ROI for a real estate investment:
- Calculate the expected annual rental income
- Subtract rental expenses from annual rental income
- Compute your % share of the net income
- Divide your net income by your total investment
According to the S&P 500 Index, the average annual return on investment for commercial real estate is 9.5%, though it’s important to remember that this number can vary significantly depending on the asset class.
How to Determine if An Investment is Worthwhile
Once you have calculated the potential ROI of a deal, you’ll then need to decide whether or not it’s an investment worth making. To help you do this, we recommend asking yourself the following three questions:
1. Is this specific opportunity suitable for me?
Consider the location. Do you believe buildings or developments in this market will maintain or increase their value in the next 5-10 years? How does the ROI for this property compare to similar properties in the same market?
You should also consider your personal risk tolerance. In many cases, a higher expected ROI will translate to a higher level of risk, and a lower ROI may indicate a lower risk investment.
2. What do the rent roll and weighted average lease term tell me about this property?
By evaluating the rent roll, you can learn crucial information about the property’s current leases, projected future income, and level of risk. For example, if there are multiple leases set to expire around the same time, or if vacancy rates are unusually high, this could increase your risk.
Rent rolls will also help you calculate the gross income you expect the property to generate, and to identify opportunities to increase that gross income in the future.
If the weighted average lease term (the average amount of lease time remaining for current tenants given the tenant size), is 3-4 years or higher that will typically indicate a level of stability for the investment.
3. Does the investment strategy make sense?
Almost any building can be a good investment, but it all depends on the strategy chosen by the deal sponsor. This is why it’s so important to work with an experienced sponsor who you trust and who has a proven track record of success.
Does the sponsor’s plan make sense to you? Are they transparent about the strategy and the concrete steps they’ll take to achieve it? Are you comfortable with the leverage point included in their model? If the assumptions in the strategy make sense and are suitable for the building and its location, then you’re generally on the right track.
Consider These Metrics Alongside the ROI
By looking at multiple data points, you can gain a fuller picture of the profitability of an investment. Instead of only paying attention to the expected ROI, look also at:
Capitalization Rate: A property’s cap rate is the annual, debt-free rate of return from a property, based on its annual net operating income and current property value.
Internal Rate of Return: IRR measures the annual ROI over a particular time period, rather than over the total time of ownership
Cash-on-Cash Return: This calculation compares the annual pre-tax cash flow from a property to the total amount of cash invested.
At Excelsior Capital, we focus on investing in stable asset classes in healthy secondary markets, and this strategy has delivered consistently strong returns for our investors. If you’re interested in learning more about our direct co-investment opportunities, please fill out this brief form to get in touch with a member of our team.
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