A commercial property investment is a business investment. Determine the investment numbers and you will determine your success ratio for performance of your investment. The following three formulas will help you to choose your level of risk, before you submit a letter of intent. Remember a commercial property is a business that is an illiquid investment. Your investors money will be tied up until you sell the property. It is a cash in cash out, income generator with costs, debits, and depreciation. The commercial property business is subject to geographic and socioeconomic factors that will determine influence ROI. Here’s how you get started with some simple calculations prior to performing complete due diligence:
CAP Rate or capitalization rate is used to determine the current or present value of a property that will create future earnings. It is a determining number used to estimate the projected value of an asset class of properties. It is also a discount rating and calculated by:
Net Operating Income (NOI) / Purchase Price = Capitalization Rate.
This following example would be considered a good rate of return. Class “A” multifamily for $1,000,000 produces $100,000 in positive net operating income (NOI) each year, then the formula would be as follows: Net Operating Income / Purchase Price = CAP Rate $100,000 / $1,000,000 = 0.10 = 10% Therefore, the commercial property’s capitalization rate is 10%, which would be the annual return on your investment.
Cash Flow is money going in and out of your commercial property business , and is determined by three things to look at annually: rents, expenses, and debt service. A simple cash flow formula:
Annual Rents – Annual Expenses – Annual Debt Service = Cash Flow
A $25,000 cash flow into your multifamily each year would be determined as follows: Class A multifamily rental return is $100,000. Annual expenses are $40,000. Annual mortgage debt service is $35,000. This means that in order to find out what your cash flow is, you would follow the formula: $100,000 – $40,000 – $35,000 = $25,000
Cash-on-Cash Return – The cash-on-cash return is the ratio of annual before-tax cash flow to the total amount of cash invested. Cash on cash formula:
Cash Flow / Down Payment = Cash-on-Cash Return
If you had put down $250,000 for your multifamily property, your cash-on-cash would be: $25,000 / $250,000 = 0.10 =10%
ROI return-on-investment cash dictates how much profit you will make on your multifamily property investment.
Total Financial Benefits / Down Payment= Return-on-Investment (ROI)
Let’s assume that before you bought your multifamily property, you were informed that your total financial return would be $35,000. You would figure out your return-on-investment as follows: $35,000 / $250,000 = 0.14 = 14%
These are simple calculations you can make when you are looking at a commercial property pro forma to determine if you want to move forward with in depth due diligence. Remember these are general numbers and only begin to tell the story before complete due diligence can be done.