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Return on Investment
Real estate investments have always been exalted as the backbone of financial stability and long term financial growth. One of the biggest reasons for investing in real estate, whether commercial real estate or residential, is that there is huge potential for a secondary income in the form of rent.
And if that second line of income is a primary goal for you as an investors, then it makes a lot of sense to carefully consider what type of property you’re putting your savings into; and which asset class will yield greater returns: residential properties or commercial real estate.
Commercial vs Residential Properties
Common knowledge dictates that a commercial property provides higher RoI than a residential property, with a similar initial investment. Based on cumulative data, the usual ROI from residential properties is around 2 to 4%, and a commercial property in a high end area can provide anywhere from 7 to 15% ROI.
However, there are various factors that affect this RoI: Location of the property, duration of the lease agreement, maintenance costs, market considerations, and so on.
Factors Affecting ROI in Different Types of Real Estate
| Factors Affecting ROI | Residential Properties | Commercial Properties |
| Stability and Consistent Demand | Consistent demand for shelter provides a steady rental income stream. | In-demand areas attract businesses willing to pay a premium for a prime location. |
| Tenant Turnover | More frequent tenant turnover, impacting cash flow and requiring effort to find new tenants. | Sensitive business tenants lead to lower turnover, reducing the effort in finding new occupants. |
| Entry Cost and Complications | Lower entry cost and lesser complications, making it accessible for novice investors. | Higher entry cost and potential complexities associated with commercial properties. |
| Contract Duration | Residential tenants prefer long-term contracts. | Businesses may relocate more frequently, leading to shorter lease durations. |
| Regulatory Environment | Simpler and more relaxed regulations on a smaller basis. | Complex laws and regulations often applied on a larger scale. |
| Return on Investment (ROI) | Typically lower ROI compared to commercial properties. | Invariably yields greater returns, especially in high-demand areas. |
| Maintenance Costs | Higher maintenance costs due to more amenities in residential complexes. | Lower maintenance costs as commercial complexes typically have fewer amenities. |
| Tenant Sensitivity | Residential tenants may not treat the property as their own, requiring more maintenance. | Business tenants, often with large enterprises, tend to have greater respect for the property, reducing maintenance needs. |
| Leasing Agreement | Typically traditional leases with the landlord responsible for property expenses. | Triple Net Lease agreements make tenants liable for property expenses, reducing the landlord’s financial burden. |
| Rental Yields and Appreciation | Lower rental yields (1.5 to 3.5%) and capital appreciation (1-3%). | Higher rental yields (8 to 11%) and capital appreciation (5-10%). |
| Lease Agreement Impact on ROI | Rental gain in residential properties is around 2-3% or less after property expenses. | Commercial properties often achieve a net yield of 7-8% due to lease agreements. |
What is a Good ROI For Commercial Real Estate?
Determining the ROI on commercial real estate is essential for investors looking to maximise their returns. While there’s no one golden number for coming up with a good ROI, here’s what you should look for while evaluating ROI on a commercial property:
The purchase cost of the property, the maintenance costs needed to get the property up to speed, which also should be included in the initial investment, ongoing maintenance expenses, and so on.
As we’ve seen above, the type of commercial property, whether it’s a high end property or not, its location, commercial market activity in the region, all these factors play a big role in determining the expected ROI.
As an investor, your investment or exit strategy deployed for the property also plays a big role. Some investors might focus on deriving returns through rental income over a long term plan. Others might be looking at property appreciation and then selling the property when the time is right.
How to Calculate ROI on Commercial Real Estate?
To put it simply: To calculate ROI, you subtract the investment cost from the anticipated returns of the investment, and then divide it by the initial investment cost.
To calculate ROI for rental income on a commercial property:
- Calculate the expected annual rental income.
- Deduct rental expenses from the annual rental income.
- Calculate your percentage share of the net income.
- Divide the net income by your initial total investment.
For example, let’s say you bought a rental property for 5 lakh rupees. It yields 35,000 rupees in early rental income, and the yearly rental expenses are 10,000 rupees.
35,000-10,000 / 5,00,00 = 5%.
Thus the ROI would be 5% using this method. According to the S&P 500 Index, the average annual ROI on commercial real estate is 9.5%.
ROI: Risk vs Return
Both commercial and residential properties have their pros and cons in the Indian real estate market. As an investor, you can capitalize on the intricacies of the market by choosing the best property for you based on your investment goals, conducting thorough research, keeping market considerations in mind, and doing your due diligence either individually or by working with market experts.
Residential properties are generally more stable in the market, with consistent high demand. But as compared to commercial real estate, the returns are also lower, although secure. Commercial properties offer much higher ROI through rental yields and the potential for high capital appreciation. But they also have risks not seen in residential properties such as tenant turnovers, economic fluctuations, and longer vacancy periods.
Bottom Line
Evaluating potential returns on different real estate investments is a multi-dimensional process; by having a good understanding of distinctive aspects of retail, office, and industrial properties, investors can strategically maximize their ROI and also diversify their portfolios.
Assetmonk, an alternative real estate investment platform, offers innovative solutions to your commercial real estate problems. By emphasising functionality, we collaborate with you to build a strong and diversified real estate portfolio, and allow you to experience the full potential of commercial property investments.
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FAQs
What is the ROI of commercial properties compared to residential?
Generally, commercial properties yield a higher return on investment (7 to 15%) than their residential counterparts (2 to 4%) when we compare them based on similar initial investments.
What factors influence ROI in real estate?
Location, tenant turnover, entry cost, lease duration, regulatory environment and maintenance costs constitute the key factors.
What is a good Return on Investment (ROI) for commercial real estate?
No one-size-fits-all number exists; however, factors such as property cost, maintenance expenditures, the location of the asset property, and market activity are significant in determining a good ROI.
What is a good method for calculating Return on Investment (ROI) in relation to commercial property rental income?
Compute the expected annual rental income, subtract the rental expenses; then divide your portion of net income by the initial total investment.
