A question we get often is “What is the ROI of Investing in Commercial Real Estate?” or “What type of returns can I expect from investing in Commercial Real Estate?”. These are great questions and could be answered in a brief statement by sharing a national average return on real estate investments, but to be fair the answer can be more sophisticated than that.
When you’re putting together a financial portfolio, one of the first things you’ll hear is that you should diversify your investments. A standard recommendation for a portfolio is to include commercial real estate. Why? Because it delivers stable returns for investors. This is why you can expect to get a positive ROI on those real estate investments.
The term “return on investment” (ROI) refers to how much money you make over the course of owning a property. The method by which you realize your real estate ROI (or return) varies depending on the sort of investment property you purchase. In some circumstances, you may have many revenue streams that contribute to your ROI and those may run in perpetuity or you may sell and exit.
Here we go into additional considerations related to the return on investment for commercial real estate.
Cash on Cash Return vs Cap Rate
When we think about return it’s a pretty simple formula, divide annual rental income minus annual rental expenses by the property value and there you have it, this is your ROI. But ROI on real estate investments isn’t always that simple and you may need to use two methods of calculation to determine your return.
- CoC Return
Cash on cash return is an ROI statistic that considers the whole amount of money spent/invested. It differs from a standard ROI formula in that it substitutes yearly pre-tax cash flow for the difference between rental revenue and expenses. The cash-on-cash calculation determines the cash income produced on the cash invested in a property. Simply put, a cash-on-cash return compares the annual return made by the investor on the property to the amount of mortgage paid during the same year. To calculate CoC return, just divide annual pre-tax cash flow by total cash invested and convert the result to a percentage.
- Cap Rate
Cap rate, which stands for capitalization rate, is comparable to CoC return. It evaluates rental property profitability regardless of financing method. This metric is derived based on the net income that the property is predicted to earn and is expressed as a percentage by dividing net operating income by property asset value. It is used to calculate the probable return on an investor’s investment in the real estate market. This makes the cap rate particularly useful for comparing properties when wanting to buy and invest. To calculate the cap rate, just divide the net operating cost by the fair market value and multiply by 100 percent.
What is a Good ROI on Commercial Real Estate Investments?
So, what can you actually consider a good return on investment in commercial real estate? The answer obviously varies depending on the area, the type of property, the current economic climate, and policy. However, on a national scale, a reasonable ROI runs between 6% to 8%. When considering CoC return and cap rate, ROI percentages tend to be slightly higher. The range of CoC, like ROI, is determined by a variety of factors. Nonetheless, the general “good” range is between 6% and 12%. As with ROI and CoC, the range of a good cap rate varies according to location and other factors. The answer to the question of what is a good cap rate is often between 6% and 12% as well.
If you aren’t currently invested in commercial real estate we hope this highlights why you should get into it, but if you are and your numbers are not within or above the returns we listed then you may need to seek out new or additional commercial real estate investments to better your ROI.
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