As a real estate investor, understanding how to effectively calculate returns is crucial in deciding which commercial properties’ investment deals align with your personal goals and business plan.

When calculating returns, there are a few different metrics commonly used. Cash flow may be flashy, but return on equity (ROE) answers the question of when it’s time to sell a property. Using metrics that allow you to properly plan and understand when to sell a property impacts your overall profit and allows you an advantage early on when investing in real estate. 

During the lifecycle of a real estate investment project, you have to not only weigh the projected profit value in cash-on-cash returns, but also find the optimal value of equity that should remain in your rental properties so you can be making as much profit as possible on your capital. Keep in mind that the ROI on real estate investment is only as good as the data you put in, and that there’s no way to completely eliminate risk. 

Return on investment (ROI) measures how much profit is made on an investment as a percentage of . Since this metric shows how well your investment dollars are being used, it pays to know both what ROI is and how to calculate ROI in real estate. ROI is an accounting term that indicates the percentage of invested money that’s recouped after deducting associated costs. Another way to think about it is total cash flow plus sales proceeds divided by total investment including debt.

Commercial real estate investments are complex and return profiles can vary greatly across asset classes and market conditions. To vet an investment opportunity, the return profile is one of many factors to consider. This article will help you understand return profiles often discussed in the real estate market, select the return profile that aligns with your desired payout and financial goals, and evaluate whether a specific return profile is right for you.

 

How to Measure Your Return on Investment

There are a few ways to measure the return profile of commercial real estate investments, and admittedly, some are better than others. One thing I want to highlight up-front is to really watch the tiniest details in “returns language.” Just one word can make a huge difference. 

For example, return OF investment versus return ON investment are two very different things. It’s good to know the difference between them.

I hope it goes without saying, but always read the fine print, do your due-diligence calculations, and ask questions!

#1 – Cash Flow

Cash flow isn’t always a great indicator of ROI. While a property may bring in a decent return each month, cash flow alone doesn’t take into account how much money is tied up in the property. If there’s a large amount of cash tied up in the property, even a good monthly return may not create a positive ROI, which is why you shouldn’t necessarily be swayed by property owners who boast about their cash flow returns.

I bet you’d be pretty taken aback if I told you that I had a rental property that paid $1,000 every month. But what if I also mentioned that I had $500,000 in equity (not debt) invested in the property? It’s not nearly as appealing. I could have earned that by putting my money into savings accounts!

 

#2 – Cash-on-Cash Return

Cash-on-cash return is the amount of money you make after expenses, divided by how much you have invested in the property. Although easy to calculate, it also may not be the best indicator of ROI in terms of future planning or if you’re using any type of creative financing.

You’ll want to figure out which is more important to you and in better alignment with what you need for your finances: steady cash flow or appreciation?

The less capital you have tied up in a property and the higher the monthly or quarterly returns are, the better the investment. But it’s important to pay attention to other factors, not just the cash coming in. That also means higher leverage, which can entail more risk.

 

#3 – Internal Rate of Return 

In a nutshell, the Internal Rate of Return is a standard metric used to compare the return on your investment with length of time included in the calculation. The IRR remains negative until you make money (through monthly or quarterly distributions) equal to the amount you invested on the front-end.

The longer you have your investment capital tied up in the deal, the lower your IRR. The faster distributions are paid to investors, the faster the IRR metric turns positive. Many investors use IRR calculations as a great way to compare deals of different rates, lengths, and styles.

 

#4 – Return on Equity 

Return on equity (ROE), in my experience, is the most powerful metric for real estate investors to accurately determine ROI. It combines the simplicity of cash-on-cash returns with the ability to plan long-term as with IRR. 

Investors wishing to find the “happy medium” between cash flow and significant appreciation over a specified period would find ROE useful as they sort through and choose investments.

Return on equity takes into account your overall ROI and the amount of equity you have in a property. It factors in actual cash flow, the fact that you’re paying down your loan balance, and any appreciation of the property.

Sounds good, right? Let’s keep going.

 

Using ROE to Make Wise Investment Decisions

Real estate investors who are more concerned with money growth and less with monthly cash flow should be using ROE (Return on Equity) to compare investment projects. In order to calculate ROE, you have to first understand equity and total annualized return.

Equity in real estate is the amount of money you would earn if you sold your property today. It’s the difference of the capital you have invested versus the value the asset would sell for. Equity grows as the value of your property rises through real estate market appreciation.

Total annualized return takes into account cash flow, mortgage principal pay down, and appreciation.

 

Here’s how to calculate the total annualized return:

Cash Flow + Principal Pay Down + Appreciation

 

Now you can calculate your ROE, here’s how:

Total Annualized Return / Equity = ROE

 

Using ROE as your go-to metric for evaluating investment opportunities can help you decide when to purchase an investment property or when to sell and invest in something else. It’s wise to regularly evaluate your investment properties to see how much equity you have and if your returns are continuing to outpace what you could earn in other investment deals.

If the value of your commercial investment property has risen significantly, you could be hindering your purchasing power by leaving more money than necessary in your assets.

A common question posed by individual investors is, what’s a good ROE? What qualifies as a good ROE in real estate depends on your risk tolerance, goals and overall business plan.

Return on equity is a powerful metric that every sophisticated real estate investor should use to help them make better decisions. By utilizing ROE in your decision-making process, you can better compare real estate investing opportunities. Using ROE as your preferred metric, allows you to build wealth faster and with less risk than relying on other metrics to analyze real estate returns. 

 

Always Consider What’s Driving Your Investments’ Business Plan

When vetting any deal the primary question should be what’s driving the business plan? In addition to determining how to calculate returns, consider if there are plans to add value to the property.

The overall, long-term plan of the property will help determine whether you’re willing to take on substantial risk and thus, the IRR, ROE, equity, and cash-on-cash return. For instance, the projected return may be dependent on a rent increase in the near future versus the current cash flow.

In some cases, the business plan is to simply purchase in-place cash flow. Perhaps, you purchase an apartment complex where you’re essentially just buying an income stream with no plans to add any value. In this example, say you like the fact that there’s no deferred maintenance and it attracts a certain tenant profile.

Sometimes you can take on lower risk by investing in brand-new commercial properties on their way to lease-up. This means the developer has done their part and, if you have leasing and property management in your skillset or on your team, you can make money by simply getting the units leased.

 

How To Choose The Best Return Profile for Your Real Estate Investments

As you vet investment deals and elect to add one to your investment portfolio, carefully evaluate which opportunities match up with your investing style, the level of risk and return you’re generally comfortable with, that reflect an opportunity for diversification, and contain a business plan that you’re comfortable with.

A reputable sponsor team will provide calculations and projections in their investment summary, carefully explaining the factors and details on how each metric was calculated. They want to make money on their real estate investments just like you do, so examine the deal structure in addition to the return metrics discussed here. You’ll want to see how the general partnership is incentivized on your particular real estate investment.

When assessing what’s driving the real estate investment’s business plan, consider what’s required with each asset profile, tenant profile, and return profile.   Find out the story on the asset, decide if you agree with the business plan and if the projections, market conditions, and choices around the current condition of the property makes sense.

Do your own research – find out the past performance of similar properties in the area, and ask questions of other investors and the sponsors on the potential real estate investment in regards to your considerations. 

The key takeaways here are to run the ROE, IRR, and whatever other metrics floats your boat, sure. But it also pays big bucks to take a step back and think about the real estate investment logically.

Does this asset’s story make sense?

Is it “worth it” risk-wise to pour a ton of cash into this investment based on the area, property type, population trends, and historical data?

Are you comfortable with taking on the risk of this particular business plan?

Have you identified risk-mitigating features of the sponsor’s investment strategy?

In the end, you’ll choose the right investment by finding comfort with the asset, any plans for adding value to it, developing a relationship with the sponsor team, and understanding the risks you’re taking in conjunction with the projected returns. If you’re ready to dive deeper and start examining our past and upcoming commercial real estate investment opportunities, join the club today!