The purchase price you pay for a commercial real estate investment only tells you what it costs to acquire, not whether the property will produce an acceptable return to justify that outlay.
To find out, you need to compare the money you can potentially gain from a property with the money you will put into it.
This calculation is called ROI, or return on investment.
What does ROI mean in commercial real estate?
ROI measures the profit generated by a property relative to the amount of capital invested.
At its most basic level, your projected ROI will answer this question: For every dollar you invest in this property, how much profit will you potentially earn?
Related blog: 3 widely used ways of calculating ROI on commercial properties
How is ROI calculated in commercial real estate?
The general formula is:
ROI = Net profit ÷ Total investment × 100
Suppose you invest $5 million in a property and earn a net profit of $750,000.
ROI = $750,000 ÷ $5,000,000 × 100
ROI = 15%
So the investment in this case produced a profit equal to 15% of the capital invested.
Note that this basic formula is only useful if you can define net profit and total investment correctly. Those figures will change depending on:
- whether you buy with cash or financing
- how long you hold the property
- whether you include appreciation
Note also that while the basic calculation looks straightforward, working out the figures that belong in it is usually anything but.
Commercial property returns rarely come from a single source: you will probably also receive rental income while you own the property, and build equity when its value increases, and then receive sale proceeds when you exit.
Many expenses will also reduce your ROI throughout that holding period, from operating costs to financing charges.
Purchase price and acquisition costs
The purchase price is defined narrowly as the amount you pay for the property itself. That figure climbs once you include acquisition costs such as:
- inspections and appraisal costs
- due diligence expenses
- brokerage and legal fees
- title charges
Do you plan on financing the purchase?
Then you also have to add lender fees and loan origination charges. Do you plan to improve the asset after? Make sure to account for repair/renovations costs.
Never divide profit by the purchase price alone. The last thing you want is to overstate the ROI by leaving those additional costs out of the denominator.
Financing costs
If you plan to take out a loan to buy a commercial property, you have to calculate the RO only on the cash you contributed instead of the purchase price in full.
Then, subtract the interest and other loan costs from the income the property generates.
So if you buy a $5 million CRE property with a $1.5 million down payment, and the property generates $550,000 in annual NOI and requires $250,000 in annual loan payments:
$550,000 − $250,000 = $300,000 in annual cash flow
Your annual cash-on-cash return is therefore 20%:
$300,000 ÷ $1,500,000 × 100
If you don’t take out a loan, you would keep the full $550,000 NOI and earn an annual return of 11% on the $5 million invested:
$550,000 ÷ $5,000,000 × 100 = 11%
When calculating leveraged ROI, account for:
- down payment
- loan origination fees
- interest expense
- principal repayment
- prepayment penalties, where applicable
- remaining loan balance at sale
To calculate your annual cash-on-cash return, subtract the year’s mortgage payments from the property’s NOI. Then divide the remaining cash flow by the total cash you contributed.
To calculate ROI over the full holding period, add the cash flow you received during ownership to the net amount you keep from the sale.
Before calculating that sale amount, subtract selling costs and the remaining loan balance.
Net operating income
NOI (net operating income) is what the property earns before any deductions related to financing costs and income taxes are made.
NOI = Effective gross income − Operating expenses
‘Effective’ gross income includes rent and other property income after vacancy and credit losses. Other income may come from additional services or facilities that the property provides, such as parking and storage fees.
Remember that NOI excludes:
- mortgage payments
- depreciation
- income taxes
- capital expenditures
So if a CRE property earns $2.4 million in effective annual income and incurs $900,000 in operating expenses:
NOI = $2,400,000 − $900,000 = $1,500,000
That property generates $1.5 million before debt service.
Operating expenses
Operating expenses are the recurring costs of owning and running the property:
- Insurance
- property taxes
- owner-paid utilities
- management fees
- security
- cleaning
- routine repairs
Make sure that you’re using realistic vacancy and collection-loss assumptions when calculating your effective gross income.
Don’t calculate NOI from full occupancy, as this can overstate the property’s expected return.
Also make sure to treat capital expenditures separately.
A roof replacement or major HVAC upgrade doesn’t normally reduce NOI but it does reduce the cash earned from the investment. Subtract these costs when calculating holding-period profit.
Appreciation and sale proceeds
A property may also produce a return by increasing in value.
Did you buy a property for $8 million and later sell it for $10 million?
That puts its ‘gross appreciation’ at $2 million. But that $2 million is not your profit from the sale. You must first subtract selling costs and any outstanding loan balance, so:
Net sale proceeds = Sale price − Selling costs − Loan payoff
Selling costs may include:
- brokerage commissions
- legal fees
- transfer taxes
- closing charges
You can then calculate total holding-period profit
Total profit = Cumulative property cash flow + Net sale proceeds − Total cash invested
All-cash purchase example
Assume you buy a retail property with cash.
Purchase price: $8,000,000
Acquisition costs: $320,000
Initial improvements: $480,000
Annual effective gross income: $1,200,000
Annual operating expenses: $400,000
Your total cash investment is:
$8,000,000 + $320,000 + $480,000 = $8,800,000
Your annual NOI is:
$1,200,000 − $400,000 = $800,000
Because there is no loan, annual pre-tax property cash flow is $800,000.
Your annual return on invested cash is:
$800,000 ÷ $8,800,000 × 100 = 9.09%
Now assume you hold the property for five years and NOI remains at $800,000 per year.
Cumulative property cash flow is:
$800,000 × 5 = $4,000,000
You sell the property for $10 million and pay $600,000 in selling costs.
Net sale proceeds are:
$10,000,000 − $600,000 = $9,400,000
Total cash received is:
$4,000,000 + $9,400,000 = $13,400,000
Total profit is:
$13,400,000 − $8,800,000 = $4,600,000
Your five-year ROI is:
$4,600,000 ÷ $8,800,000 × 100 = 52.27%
All-cash vs leveraged purchase ROI
Suppose two investors buy the same $12 million warehouse and hold it for five years.
| All-cash Purchase | Leveraged Purchase | |
|---|---|---|
| Purchase Price | $12,000,000 | $12,000,000 |
| Cash Paid Toward Purchase | $12,000,000 | $3,600,000 |
| Acquisition and Loan Costs | $360,000 | $480,000 |
| Initial Improvements | $420,000 | $420,000 |
| Total Cash Invested | $12,780,000 | $4,500,000 |
| Annual NOI | $1,260,000 | $1,260,000 |
So as you can see here, the leveraged investor receives less total profit but records a higher percentage return because they invested much less of their own cash.
Related blog: What’s a good enough ROI in commercial real estate? Find out.
ROI vs other commercial real estate return metrics
ROI is useful but can’t stand on its own, which is why CRE investors often compare it with these other metrics:
Cash-on-cash return
This is the measure of the annual pre-tax cash flow you might receive from the property relative to the cash you invested in it.
Cash-on-cash return = Annual pre-tax cash flow ÷ Total cash invested × 100
So if you invest $6 million and receive $540,000 in annual cash flow after making the loan payments:
$540,000 ÷ $6,000,000 × 100 = 9%
Your cash-on-cash return is 9%.
Capitalization rate
This compares the property’s annual NOI with its purchase price or current value.
Cap rate = NOI ÷ Property value × 100
So if a property produces $1.2 million in annual NOI and is valued at $15 million:
$1,200,000 ÷ $15,000,000 × 100 = 8%
The property has an 8% cap rate.
Internal rate of return
IRR shows the investment’s average annual return over the full holding period, accounting for when you invest money and when you receive income.
It could be more useful than basic ROI if you want to compare properties held for different lengths of time.
For example, you might earn a 50% ROI on one investment over three years and the same 50% ROI on another over ten years.
A basic ROI calculation will show the same 50% return for both, but an IRR calculation will show that you earned the return faster on the first investment.
Related blog: Benefits and limitations of the ROI calculation
Equity multiple
Equity multiple shows how much total cash you will receive over the life of the investment compared with the amount of equity you’ve invested.
Equity multiple = Total cash received ÷ Total equity invested
So if you invested $6 million and received $10.8 million over the full holding period:
$10,800,000 ÷ $6,000,000 = 1.8×
That 1.8× equity multiple means you received $1.80 for every $1 invested.
Which metric should you use?
| If you want to measure this | Use this |
|---|---|
| Total profit relative to the amount invested | ROI |
| Annual income relative to the cash you invested | Cash-on-cash return |
| Property income before financing | Cap rate |
| Returns over a longer holding period when timing affects the result | IRR |
| Total cash received relative to your original equity | Equity multiple |
It often makes sense to calculate more than one metric: combine ROI (which shows the overall result) with other metrics that explain how the property generated that ROI.
What can distort your commercial real estate ROI?
Leverage
Borrowing money to finance part of the purchase can increase the ROI on paper because you’re investing less of your own cash. It doesn’t necessarily mean that the property itself performs better.
Let’s say that two investors buy identical $10 million properties that each produce $800,000 in annual NOI:
| All-cash Purchase | Leveraged Purchase | |
|---|---|---|
| Purchase price | $12,000,000 | $12,000,000 |
| Cash paid toward purchase | $12,000,000 | $3,600,000 |
| Acquisition and loan costs | $360,000 | $480,000 |
| Initial improvements | $420,000 | $420,000 |
| Total cash invested | $12,780,000 | $4,500,000 |
| Annual NOI | $1,260,000 | $1,260,000 |
Leverage raises the cash-on-cash return from 8% to 9.33% in this case because the financed investor contributes much less cash.
However, if NOI falls to $500,000, the financed investor loses $20,000 that year after making the loan payments:
$500,000 − $520,000 = −$20,000
Vacancy
Suppose a property could generate $2.4 million in annual rent at full occupancy. If you assume 10% vacancy, expected rental income falls by $240,000:
$2,400,000 × 10% = $240,000
Expected rent after vacancy is therefore:
$2,400,000 − $240,000 = $2,160,000
That $2.16 million is still not necessarily the amount you will collect, because you may also lose income through tenant defaults or agreed rent-free periods.
Capital expenditure
NOI deducts recurring operating expenses but usually excludes major capital expenditure, so it can overstate the cash you actually keep.
If a property generates $1.5 million in annual NOI but requires a $2 million roof replacement during the same year, your cash flow for that year (before financing) is:
$1,500,000 − $2,000,000 = −$500,000
The property still reports $1.5 million in NOI, but you spend $500,000 more than it generates that year.
Holding period
Total ROI will only show how much you earned but not how long it took to earn that.
Holding a property for longer may increase the rent you collect and allow more time for its value to rise. It also gives you more years of operating costs and capital expenditure.
Taxes
The IRS lets you write off the building’s value over time.
Here’s how that depreciation might affect your ROI if you invested $10,000,000 in equity into a commercial property generating $4,000,000 in net operating profit over a multi-year holding period, and you claimed $1,000,000 in total depreciation:
$4,000,000 profit − $1,000,000 depreciation = $3,000,000 taxable
$3,000,000 × 30% = $900,000 tax bill
$4,000,000 profit − $900,000 tax bill = $3,100,000 net profit
$3,100,000 net profit ÷ $10,000,000 equity × 100 = 31% After-Tax ROI
Without depreciation shielding that $1M, your tax bill would have been $1.2M. This would have reduced your ROI down to 28% instead of 31%.
Will the right financing improve your ROI?
Submit your CRE loan scenario to Private Capital Investors. We can design a loan that makes sense for your goals.
