5 Tips for Calculating ROI on Commercial Property Investments

If you get it right, investing in commercial real estate can be highly lucrative. However, the path to success involves making some accurate calculations and taking into account a whole host of factors that could influence how your investment fares.

Whether you are acquiring these investments through commercial property auctions or have been made aware of an opportunity through an agent, the same rules of engagement apply.

Ultimately, your long-term profitability and success depends on accurately assessing return on investment (ROI). By calculating ROI you can make informed decisions, mitigate risks, and maximize your profits.

Here is an outline of some essential tips to help you calculate ROI effectively. There is also a look at why numeric accuracy is so crucial for long-term financial success.

What is Return on Investment (ROI)?

A good starting point would be to gain an understanding of what ROI actually means.

Put simply, Return on investment (ROI) is a simple way to measure how profitable an investment is. It is a calculation that is designed to tell you how much money you make compared to how much you spend.

It is important to know that ROI is usually shown as a percentage. The reason for this is that it makes it easier to compare different investments. In essence, the higher the ROI, the better the investment. For example, if you invest $10,000 and make $2,000 in profit, your ROI is 20%.

Having a good comprehension of ROI will help you make sounder investment decisions. It is a good way to determine if a property is worth the money, how long it will take to recover their investment, and whether it’s a good financial decision overall.

Why an Accurate ROI Calculation Matters

If you are going to be investing a significant sum of money in buying a commercial property you will want to cover all bases beforehand so that you know that your reasons for buying the asset are supported by the numbers.

An accurate ROI calculation provides valuable insight into the profitability of a commercial property investment. It helps clarify and guide your investment decisions when you compare different potential investment properties. It is also a proven way of assessing risk, and determining whether a deal aligns with your financial goals.

Without a doubt, miscalculating ROI can lead to poor investment choices, unexpected costs, and even diminish your returns. By using reliable methods to calculate ROI you can be more confident that your decision to invest stacks up.

Understanding a Basic ROI Formula

The simplest way to calculate ROI is using a simple formula. Here is an outline of how to make a basic, but accurate, calculation.

ROI=(NetProfit÷TotalInvestment)×100 ROI = (Net Profit ÷ Total Investment) × 100

Where Net Profit = Total Revenue – Total Expenses

and where

Total Investment = Purchase Price + Additional Costs (renovations, closing fees, etc.)

To give you an example of this in practice.

Let’s assume you buy a property for $500,000 and spend $50,000 on renovations. Once you have completed the work and found a tenant to rent the property, you manage to earn $60,000 annually in rental income after expenses.

Using these numbers, your ROI is:

(60,000÷550,000)×100=10.9(60,000 ÷ 550,000) × 100 = 10.9%

Although you now have a calculation that gives you your ROI, this only really provides a quick profitability snapshot. This is because  it doesn’t include factors like financing or property appreciation.

Consider the Cash-on-Cash Return

Many commercial property deals are supported by bank or private equity finance. If you are using finance to complete the purchase of your investment, there is a formula that can be used to give you a clearer illustration of your earnings. This calculation is called the cash-on-cash return.

The formula is as follows:

Cash−on−CashReturn=(AnnualCashFlow÷CashInvested)×100 Cash-on-Cash Return = (Annual Cash Flow ÷ Cash Invested) × 100

To help you understand how this formula works, let’s use another example to illustrate the calculations used.

Let’s say that you put $100,000 down on a $500,000 property, and you then manage to achieve annual earnings of $12,000 after deducting your expenses.

Using this example figures, your cash-on-cash return is:

(12,000÷100,000)×100=12(12,000 ÷ 100,000) × 100 = 12%

What’s important to remember is that this method is designed to focus on your actual cash investment rather than the full property value.

Account for Net Operating Income (NOI) and Cap Rate

Another formula to use is NOI. The Net Operating Income (NOI) and cap rate helps assess a property’s profitability.

The NOI Formula works as follows:

NOI=GrossRentalIncome−OperatingExpensesNOI = Gross Rental Income – Operating Expenses

Again, let’s run an example to see how this calculation reveals the numbers you are looking for to gauge the profitability of your commercial property.

If your property is achieving a rental income of $80,000, and you have operating expenses of $30,000, the NOI equals $50,000

What you need to know is that the cap rate compares different properties and is calculated as:

CapRate=(NOI÷PropertyValue)×100 Cap Rate = (NOI ÷ Property Value) × 100

For a $600,000 property, for example, the formula would look like this:

(50,000÷600,000)×100=8.3(50,000 ÷ 600,000) × 100 = 8.3%

What a higher cap rate can indicate is when you are capable of higher potential returns but greater risk at the same time.

The Need to Factor in Appreciation and Depreciation

As you would expect, market conditions can sometimes be subject to turbulence and volatility. That means property values change over time. What this means is that appreciation increases value, while depreciation affects taxes.

Put simply, if a property appreciates by 5% annually, its value rises over time. However, with depreciation, you might find that this reduces taxable income, meaning you could owe less in taxes.

With this in mind, you can use a more complete ROI calculation that includes appreciation:

AdjustedROI=((NetProfit+AnnualAppreciation)÷TotalInvestment)×100 Adjusted ROI = ((Net Profit + Annual Appreciation) ÷ Total Investment) × 100

This formula offers a more comprehensive picture of long-term gains.

The Path to an Accurate ROI is to Include All Expenses and Hidden Costs

Last but not least, it pays to be mindful that in order to get a truly accurate ROI, you must aim to include all expenses.

Here is a look at what expenses need to be accounted for in your calculations:

Property taxes

Maintenance and repairs

Insurance

Property management fees

Mortgage payments

Vacancy periods

Legal and administrative fees

Without an accurate and comprehensive formula you could discover that a property with an initially high ROI might turn out to be less profitable when hidden costs are accounted for.

The bottom line is that accurate ROI calculations are excellent for helping you to make smarter commercial property decisions. By using these different ROI methods you will be improving your chances of achieving long-term success in the commercial real estate market.