Return on Investment (ROI) for Investment Real Estate article
How is the Return on Investment (ROI) for Investment Real Estate calculated for commercial real estate investments and developments? What are the factors that the Return on Investment (ROI) for Investment Real Estate takes into consideration when shown in a proforma income statement, and what is ignored? Why is the Return on Investment (ROI) for Investment Real Estate useful for investment real estate? These are the questions that are explored using the Proforma Example in this article.
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How is Return on Investment ROI calculated?
If you ask someone what the Return on Investment ROI is for an investment analysis, what should you expect as an answer? This quote illustrates the problem.
"In finance, rate of return (ROR), also known as return on investment (ROI), rate of profit or sometimes just return, is the ratio of money gained or lost (whether realized or unrealized) on an investment relative to the amount of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or net income/loss." (Source: Rate of Return From Wikipedia, the free encyclopedia; redirected from Return on Investment). Wikipedia lists several different calculations under the ROI term.
In commercial real estate, Return on Investment ROI normally refers to a group of one year ratios that assume the original investment is returned at the end of the year. Since most commercial real estate investments are multiple year investments, the Return on Investment (ROI) ratios only reveal part of the picture.
Where is the Return on Investment (ROI) on the report?
Many people getting into commercial real estate wonder where the Return on Investment (ROI) is included on real estate reports. While there are no specific measures or ratios in commercial real estate that are called Return on Investment (ROI), there are many that can be described as Return on Investment (ROI) type ratios. All the ROI ratios are essentially a single year cash flow divided by an investment corresponding to the cash flow. Since almost all commercial real estate investments last multiple years, and it is highly unlikely that the sale of the property will return the exact amount of the original investment, none of the ratios produce a number that is a rate of return number (like the IRR) that can be compared to yields on other multiple year investments. The ROI ratios (or, as planEASe calls them, profitability ratios) attempt to spotlight how the investment is doing each year. Each ratio listed (except the Gross Income Multiplier) uses a cash flow number divided by an investment number. These are all ratios that show a Return on Investment (ROI):
- Net Capitalization Rate or Cap Rate (Ratio)
- Net Operating Income divided by the Price of Property at Acquisition
- Adjusted Capitalization Rate (Ratio)
- Net Operating Income divided by the Price of Property at Acquisition adjusted for additional investments and dispositions made since acquisition. Additional Investments includes any and all TI's and Commissions scheduled due to the use of Market Profiles.
- Cash-on-Cash (Ratio)
- Net Operating Cash Flow divided by Initial Equity
- Adjusted Cash on Cash (Ratio)
- Net Operating Cash Flow divided by Initial Equity adjusted both for additional investments and dispositions made since acquisition, and for additional loans and loan repayments since acquisition.
- Gross Income Multiplier (Ratio)
- Sale Value divided by the Gross Income, testing the assumption for the appreciation of the property.
- Current Rate of Return (Ratio)
- Net Operating Cash Flow plus the year's increase in Sale Proceeds Before Tax divided by beginning Sale Proceeds Before Tax. This ratio measures the annual percentage increase in the current invested capital.
- Accounting Rate of Return (Ratio)
- Net Operating Cash Flow plus Equity Buildup plus Appreciation divided by Initial Equity.
- NOI/Property Value (Ratio)
- Net Operating Income divided by the Sale Value. This ratio is also known as the overall capitalization rate, which tests the assumption for the appreciation of the property.
What about the Rate of Return?
Usually, when someone asks for the Rate of Return on an investment, they mean the Internal Rate of Return (IRR) and they expect a 'Time Value of Money' measure to be the answer. These are all 'Time Value of Money' measures:
Summary
Asking for the Return on Investment (ROI) is common in commercial real estate, but it is a general term that has many answers. Hopefully this article will enable you to find the specific ratio or measure that best meets your needs. Since most commercial real estate investments last for multiple years, they are best analyzed with some or all of the measures that fall under the Time Value of Money' umbrella.
Written by
Michael Feakins, CCIM
of planEASe Software