What Is a Good ROI in Commercial Real Estate?

All real estate investors have ROI on their mind, especially when it comes to the commercial sector. This stands for “return on investment”, and it’s one of the most critical formulas to understand when buying or selling a property or business.

The question of what a good ROI in real estate is not easy to answer, as there are several considerations in the equation. In this post, we’ll explore the signs of a good investment as well as when you might want to walk away from a particular property.

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How to Calculate ROI on Real Estate

The traditional ROI formula will help you understand how much return a property might offer in contrast to the cost of acquiring and maintaining it. The formula is as follows:

ROI = (Gain on Investment – Cost of Investment) ÷ Cost of Investment x 100.

Your gain represents what you stand to earn either by selling the property for a profit. The total cost of investment covers your initial down payment, your closing costs, interest charges, and any repairs or renovations you face along the way.

How do you find the right commercial property to buy? The posts below can help you spot the perfect opportunity:

A Hypothetical Real-World Example

Here is a big picture explanation if you’re the type of person whose eyes glaze when faced with a mathematical formula.

Imagine that you purchased a property in the GTA and sold it a few years later. To keep it simple, let’s say that you paid $200,000 for it (a steal in today’s market, but remember this is just an example to show how the numbers work). You also pay $50,000 in closing costs and general maintenance.

Later on, you sell that property for $300,000.

Your gross gain on investment is $100,000 ($300,000 – $200,000). Divide $100,000 by your total cost of investment and multiply it by 100, and we see that your ROI is 40%.

That’s great to know, but what can you do with this information? Knowing the numbers is critical when facing your next decision.

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What It All Means

All on its own, a 40% ROI may sound impressive. But it really doesn’t mean anything unless you have some context and something to compare it to. To better understand how to actually use this number to make a decision, let’s put aside commercial real estate for a moment and talk about something we can all appreciate: food.

Imagine you have 100 apples. Your neighbour only has 80. You look around and all of your other neighbours also only have between 60 and 80 apples. You have more than most, which means your 40% is significantly above market, so in this case, it’s an excellent return.

Could a 40% return actually be a bad ROI?

Once again, you need some context. Start by asking how long it took to get all those apples.

If you did it all in one year, that would be outstanding.
If it took you 5 to 10 years, it’s not quite so satisfactory. Your annualized return matters.

Another consideration is the effort it took you to reach your goal of 100 apples. If you had to get out there and plow the fields, plant the seeds, water the crops, fertilize the soil, and pick the apples by hand, then you might decide this investment is not worth it after all.

Lastly, explore the possibility that there may be an easier or faster way to achieve your goals. Perhaps, you may be better off growing peaches instead. If you could grow 200 peaches with the same amount of effort and investment that it took you to get 100 apples, and sell them for more money, then maybe you need to reconsider what line of business you pursue.

Knowing your percentage of the return on investment is important, but only as one piece of the puzzle. The more information you have, the more data you can crunch, and the better decisions you can make.

Cash-on-Cash Return Formula

There’s more to a successful investment than just the long-term wealth potential. You might be able to buy a property for $200,000, then sell it for $300,000 (or grow 100 apples with minimal effort). However, none of that matters if you can’t carry the expenses in the meantime.

That’s where the Cash-On-Cash Return formula is helpful. It allows you to understand how much income you can generate versus your regular expenses.

Start by calculating your gross and net cash flow, and divide it by the total amount you need to invest in the property. Next, multiply that number by 100. This will give you your cash flow percentage.

In this example, let’s imagine that you can reasonably expect to earn $30,000 in gross rental income. Your total expenses work out to $10,000. This gives you a net operating income of $20,000.

Since you didn’t pay for the entire purchase price of the property out of your own funds, you will also have a mortgage, which means you’ll pay the principal plus interest on your loan. In this case, you have a loan of $160,000 at 6.5% interest, which works out to $12,135 annually.

Subtract that from your net operating income of $20,000, and you are left with a before-tax cash flow of $7,865.

You now have all of the numbers that you need to calculate your cash-on-cash return. Divide your $7,865 by the $90,000 in expenses so far. Next, multiplying by 100 gives you a cash-on-cash return of 8.74%.

Do you have more questions about commercial real estate or investing? You’ll find answers in the posts below:

What It All Means

The purpose of this exercise, believe it or not, is not to subject you to a boring math lesson or to help put you to sleep at night. There is a method and madness behind all of these calculations, and they are to help you make the best decisions when buying, selling, or investing in real estate, or anything else for that matter.

A return of $7,865 might not look exciting at first glance. However, knowing that your cash-on-cash return is 8.74% gives you a crystal clear benchmark that you can use to compare this investment with other opportunities. Is it a good ROI? It depends.

If this property offers over 8%, but another venture offers only 7%, it’s an excellent ROI. Next, think of how much risk is involved and whether or not another vehicle will get you to your goals faster or with less effort.

Weighing in on all of these factors will make you a better investor. Just remember that no one person is an expert in everything, which is why you want to surround yourself with professionals and experts.

An experienced commercial real estate agent can help you understand what all these numbers mean specifically to the Toronto market and how they align with your goals. With their help and expertise, you can become an unstoppable force.

A commercial real estate Toronto specialist is an essential partner when buying, selling, or investing in industrial properties. Connect with me at OMarjanovic@kw.com or call 647.620.2882 to learn more.