Do You Really Know Your Return On Investment (ROI)?
Updated: Feb 22, 2019
WHAT’S YOUR COMMERCIAL REAL ESTATE RETURN ON INVESTMENT (ROI)? Is the often-quoted Capitalization Rate (Cap Rate) your ROI? Not in my opinion!
The Cap Rate is derived by dividing one year’s Net Operating Income (NOI) by the purchase price. NOI/Purchase Price = CAP Rate. Unfortunately, a Cap Rate is simply a one-time snapshot based upon current or trailing 3/6/12 months of NOI. The Cap Rate does not factor in leverage, future capital expenditures, expense and rent fluctuations, vacancy or future sales price. Thus, while a Cap Rate can be a useful tool for some, it is not the best indicator of future returns for most investors. If you’re investing in a true long-term triple net lease property with a credit tenant, then using a Cap Rate is reliable and acceptable. In my opinion, Cap Rate is not the best method to use for most real estate investors in the Acadiana market.
If you’re a savvy investor and what to know your real ROI, or should I say potential ROI, you should use a version of the Internal Rate of Return (IRR) method. The IRR can be a more useful tool in evaluating the returns on a property over the entire holding period. The IRR is calculated by taking all projected future cash flows (positive and negative), the projected sales price at the end of the holding period and discounting them back to a zero-present value. Thus, all future cash flow items, revenue, expenses, capital expenditures, and future sales prices can be modeled to better predict future returns.
Like the old saying goes, “Garbage In - Garbage Out”. For one to build an accurate IRR decision model, one also needs to understand all aspects of the property you are purchasing. Remember to include future capital expenditures such as a roof, HVAC, parking lot, etc. Therefore, it is imperative that you conduct a thorough due diligence on the property and factor in all potential variables. This is where I have seen most investors fall short in their ROI analysis.
The formula for IRR is:
0 = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 + . . . +Pn/(1+IRR)n
where P0, P1, . . . Pn equals the cash flows in periods 1, 2, . . . n, respectively; and IRR equals the project's internal rate of return.
Fortunately, I do not have to use this formula since I have powerful and sophisticated Excel models developed by CCIM that do all the work for me.
I have found that the IRR model is great tool for sensitivity analyses, whereby I can develop various scenarios such as best, worst and most likely cases. Sensitivity analysis is a “what if process” of changing input variables to determine how sensitive your desired ROI is to changes in any one or multiple variables. Input variables include debt vs cash, vacancy rates, escalations in rent and expense, reserves for cap-ex and projects sales price, among many other potential variables. This process along with market knowledge, product knowledge, and gut instinct is one of the best ways to analyze and purchase investment real estate. Best way to ensure you’re making an educated decision is to seek help from an experienced and competent commercial real estate agent.
Tim Skinner, CCIM, is a commercial real estate agent with Scout Real Estate in Lafayette, LA and can be reached at (337) 443-0880.