Everyone’s heard of cash on cash returns, but there are other ways to determine how
successful a real estate investment is. Today, I’m going to show you How To Calculate Commercial
Real Estate Investment Returns using my three go-to calculations: Cash on Cash, Internal
Rate of Return, and Return on Equity, which is where many investors miss out.
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If you’re investing in commercial real estate, you’re probably looking for a return on
your capital. And one of the most attractive aspects of
having commercial real estate investments is that you can receive monthly dividends
through cash flow while hopefully gaining appreciation on the property.
But you need to have a concrete method to be able to determine which investment you
should take on next or how your current portfolio has performed after acquisition.
Up first, the Return On Investment (ROI) Or Cash On Cash return.
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The ROI or cash on cash return is the most commonly used investment measurement in all
of real estate. Return on investment is calculated by taking
the monthly or annual cashflow of an asset and dividing it by the total amount of money
you invested into a property. For example:
Say a property receives $10,000 in cash flow and you invested $100,000.
You divide that $10,000 cash flow by the $100,000 down payment, which gives you a 10% cash on
cash return. In this scenario, your investment is giving
you 10% of the original amount of money you invested every year - not a bad deal!
You could also consider cap rates as a member of the cash on cash return family, since they’re
technically a cash on cash return if you were to buy a property with all cash and no debt.
What are the Benefits Of using ROI? Well, there’s a reason the cash on cash
return is the most commonly used measurement in real estate.
It’s very simple to understand. It gives you a quick snapshot of the profitability
of a deal in a way that is easily compared to the stock market or other investment vehicles.
And the ROI is just a great way to determine returns since it’s based on the cash out
of pocket you will be deploying.
But, there are Drawbacks Of using ROI, as well.
While the simplicity of the cash on cash return is a benefit, it’s also a drawback.
The ROI only gives you a measurement of return based on the initial investment you made into
the property at a specific point and time. Your time value of money isn’t taken into
account, which isn’t too important for some investors, and it also doesn’t measure your
return based on your built up equity in the property.
Next up, the Internal Rate Of Return or (IRR) ________________
The internal rate of return is a more high-level investment measurement.
This measurement takes your initial investment, cash flow distributions, and the length of
the investment into account in order to determine your returns over time.
There’s no simple way of actually calculating IRR, so I recommend using a computer program
like Excel. For example:
In this scenario, you make a $100,000 investment for a period of 5 years.
Over that time period, you’ve received $45,000 in cash flow, which some investors would equate
to a 45% cash on cash return over the 5 year period - certainly not a bad cash on cash
return. But since IRR takes into account the amount
of money you have invested over that time period, you’ll see that the return according
to the IRR is actually 8.83%.
What are the Benefits Of using IRR? Internal rates of return account for the amount
of time that your money is invested. Unfortunately, while the cash on cash return
is helpful to determine the initial quality of an investment, it’s only a snapshot - frozen
in time. Utilizing IRRs gives you the opportunity to
compare the different lengths of investments, as well as their prospective returns, to help
you determine which direction is best for you to take.
But there are some Drawbacks Of IRR, too. Calculating your internal rate of return can
be very complicated. It’s not a measurement that you can simply
perform in your head while looking at a potential investment opportunity - you will have to
add it into your underwriting spreadsheets. Your IRR calculation will also take into account
future cash flows and estimated sales costs, which aren’t concrete numbers.
Finally, the Return On Equity or (ROE). ________________
The return on equity is arguably the most forgotten or neglected measurement of investment
returns but it should be at the top of every sophisticated investor’s list.
ROE takes into account your total equity, including equity that has built up over time,
and measures your cash on cash returns against that instead of your initial investment.
For example: You buy a property and have $100,000 in equity
to start. As your property appreciates by 3% each year,
your cash flow remains the same at $10,000 per year, but your return on equity decreases.
This scenario is very common among triple net (NNN) properties where the rent remains
flat for extended periods of time. You’re building up equity in the property
while your cash flow remains the same, so while you may have had a strong initial return
on investment, each year that number will decrease.
You now have what I call “captive” equity that you’ve created in this project but
isn’t returning you anything on your investment, so you can choose to either refinance, take
out a line of credit, or sell the property in order to put that capital into play.
What are the Benefits Of the ROE calculation? Your return on equity will show you if you
have capital in play that isn’t giving you a strong enough return.
At some point during your investment, you will cross a threshold where the returns on
the built up equity are lower than other opportunities you may have.
Return on equity can tell you when it’s time to pull that capital out or divest of
that project.
Now, there are also Drawbacks Of ROE. While return on equity is an excellent measurement,
it tells you returns based off of essentially “phantom” equity.
Sure, the equity is there in the property, but you either have to sell the property to
realize the gain from the equity, refinance, or take out a line of credit.
It’s nice to know that you have more capital created in the project, but it can also be
frustrating if you don’t have any opportunities out there to move into.
So, Which Is Best: ROI, IRR, Or ROE? ________________
Well, that’s an excellent question. Sophisticated investors will be utilizing
all three of these consistently throughout each project in order to better monitor their
money as it works for them. Every investor will have their favorite real
estate calculation, though, depending on the type of investments they’re making.
One nice aspect of these measurements is that they give you a different view of your returns
at each stage of your investment: before, during, and after.
I recommend using all three throughout the life of your project so that you can maximize
your potential investment returns.
So, there’s your rundown on calculating commercial real estate investment returns.
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