Real estate investment offers a solid path to financial growth, encompassing residential, commercial, and rental properties. Navigating the complex world of commercial real estate requires a keen understanding of key financial metrics. This article sheds light on four essential metrics that you can use to evaluate the economic performance and potential returns of commercial properties, making informed decisions that align with your investment goals.
Cap Rate
The cap rate, shorthand for capitalisation rate, is one of the commercial real estate’s most fundamental investment concepts. It is the annual rate of return an investor would earn on an investment if they had purchased the property at market value today and held it unleveraged. Calculating the cap rate is a straightforward formula:
Capitalisation Rate = NOI or Net Operating Income / Property Value
The values mentioned in the formula are:
- Value of property: This is the latest market value or worth.
- Net operating income (NOI) refers to the annual income generated by the property after accounting for operating expenses like property taxes, insurance, and maintenance costs. It is the most critical number because it directly affects the property’s cash flow.
When interpreting the cap rate, a higher cap rate means a greater risk and potential return on your investment. The reasons can be property location, property age, or market timing. A low cap rate means the investment is risky and has low success potential.
For example, long-term triple net (NNN) agreements typically show lower cap rates due to their stability as high-credit tenants in prime locations, making it an attractive, low-risk investment for many property investors.
However, remember that the cap rate also depends on other values, such as the economy, interest rates, and investor sentiment. If you’re a commercial property investor, knowing the cap rate and its components will help you calculate a return on your property investment.
Net Operating Income (NOI)
Net Operating Income (NOI) is essential for real estate investments, providing a tangible view of a property’s profitability. It is the income formula annually generated by a property after all operating expenses (but before including debt service, capital items, and income taxes). NOI has a simple calculation and formula:
Net Operating Income = Total Gross Operating Income – Total Operating Expenses
The values mentioned in the formula are:
- Operating Expenses are the expenses spent on property upkeep. These include property taxes, insurance premiums, utilities, maintenance and repair costs, property management fees, and marketing expenses.
- Gross operating income (GOI): GOI is the income you make from your property before any expenses are deducted. It includes income from income-generating revenues such as rent, parking fees, laundromat, or vending machines.
A healthy NOI is an encouraging sign of a property’s financial health. It indicates that with proper management, it is generating enough income to cover its operating expenses. Usually, a higher NOI means a more stable income for investors, as it lowers the risk of not receiving the total amount.
However, NOI is only part of the overall picture. While a high NOI is attractive, you must also consider the property’s location, tenant quality, lease terms, and overall market conditions. Investors can use these factors in combination with NOI to evaluate whether or not a given real estate investment stands a chance of being profitable.
Cash-on-Cash Return
Cash-on-cash return is a formula that tells you if your investment is profitable. This is especially useful for investors who use leverage or loans to buy properties. Cash-on-cash return is the total calculated annual money you generate on a property before tax is deducted. You can calculate the cash-on-cash return using the following formula:
Annual Cash-on-Cash Return = Annual Pre-Tax Money Flow / Total Money Invested
The values mentioned in the formula are:
- Annual cash flow before taxes: The annual income produced by the property after taking out all operating expenses, but before taxes, indicating the cash flow that is available for sale to the investor
- All-in cash is the total cash invested in the property, including the down payment and closing costs.
The higher the cash-on-cash return, the better the investment. This indicates the property has produced a solid ongoing cash return based on the original amount invested.
But a high cash-on-return doesn’t mean the property is worth investing in. That also depends on other aspects, such as the location, tenants, and potential long-term capital gain.
Internal Rate of Return (IRR)
This complex financial measure sums up how lucrative an investment is in one number. It determines the average annual appreciation rate of an investment over its whole life. IRR is calculated using a financial model. The discount rate will make the NPV or net present value of all cash flows equal to zero from an investment. The IRR is the same as this discount rate.
Calculating IRR is not straightforward and requires financial software tools or spreadsheets where necessary. However, IRR will help investors determine whether their investment table is profitable over the years.
Endnote
These four commercial real estate metrics are valuable for making informed investment decisions. Investors can identify lucrative opportunities while minimising potential risks by carefully evaluating these statistics and other factors like property location, tenant quality, and market conditions. Remember that although these metrics are important, a holistic approach to ensuring long-term success in commercial real estate investing is important.
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