We are in the process of acquiring several commercial real estate properties in the West Coast area. This will be our first investment in the U.S. We would like to set a reasonable expectation on what we can get from each property. With so many factors interacting in real estate (maintenance, operation, loans, etc.), we are wondering what some of the key factors are that we need to pay attention to when calculating ROI of U.S. commercial real estate properties.
In addition to what you’ve already mentioned, depending on the type of assets and/or employees involved, you should add: the cost of insurance, employee benefits (union or not), tax obligations (corporate and personal) and the foreign exchange rate risks.
Most U.S. investors look at pre-tax net cash flow (after debt service) and net operating income, as well as net proceeds of sale to determine ROI for commercial real estate investments. So, for example, let’s say you purchase a property that has a $95-million purchase price and an all-in capitalization of $100 million (i.e. there are $5 million of total closing costs), and you borrow $50 million (50 percent loan to capitalization but a bit over 50 percent loan to acquisition cost) at a fixed rate of 4.5 percent total principal, plus interest constant of 5 percent per annum, and that the acquisition was at a going-in return of 5 percent on total capitalization. That would give you debt service of $2.5 million and, based upon an NOI of $5 million, but let’s assume that you also had to spend $5 million on capital expenditures over the first two years. That would mean no cash flow in the first two years as you spent all cash flow on capital expenditures (including any leasing commissions). But assuming you spent those funds in the first two years to increase cash flow, let’s say that in years four to five, your NOI increased to $5.5 million and you planned to sell after year five. To make things simple, let’s assume you received $7.5 million in cash flow for years three to five and on sale, at a cap rate of 5 percent, received $110 million and had to retire a loan which had amortized $2 million of its debt, so $48 million needed to be repaid. Let’s also assume $5 million of closing costs (brokerage, transfer taxes, legal, etc.). Thus, you would have received $22.5 million in cash flow for five years, plus net sales proceeds, after repayment of debt, of $57 million, or a return of $77.5 million on a $50 million equity investment over a five-year hold period. Many U.S. investors would also calculate the internal rate of return and also use that as a metric, but many would just look at ROI. While this is a pretty simplistic example, I hope it helps to answer your question.
Broadly speaking, commercial property investment relies on making most of its return from rental income, whereas residential investments tend to rely more heavily on making a capital gain. Doing your figures before you invest is critical to make sure your investment return is worth the risk. One indicator of return is rental yield. To work out your yield, use the following formula: gross rental yield = [annual rental income/total property expense] x 100. This figure tells you the rate of income return as a percentage of the property. It is often used as a comparison metric in property. Commercial properties average around 7 percent to 7.5 percent yield. A higher yield tends to mean higher income, which will help with servicing the property’s expenses (such as loan costs). The other key indicator of return is your capital gain; that is, how much money you stand to make when you sell due to the increase in value of your property. Usually a property with a higher yield will have lower capital gain potential. A commercial investor wanting to make a significant capital gain would usually need to buy a property with scope for improvement or expansion. Otherwise, you should ensure your net rental yield is high enough to provide satisfactory return on your investment.
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