Listen to the article
There have always been suspicions around CRE being a good source of investment. While some believe that investing in a good commercial property can result in good fortune, others find CRE investment as a risky business. The questions around CRE investments often pertain to the investment-gain comparison, where many investors miss the mark of understanding the returns of CRE investments.
Before accepting or rejecting the idea of CRE investing, it is vital to gain knowledge about the possibilities of the returns which can be generated by the investment.
How Does One Generate Income From Commercial Real Estate?
The investments made in a commercial real estate property can be used to generate returns in two ways-
- Either by leasing the property for a specified period, which will lead to generating the rental income
- Or, the property itself generates some income as a result of appreciation, which occurs over the years
What Is a Rental Income?
As stated above, one of the ways of gaining a return from CRE investments can be through giving the property on rent to any corporate authority such as office workspaces, industrial warehouses, retail market outlets, or banks. Thus, the income generated from this leasing is known as rental income, which acts as revenue. The rental income can either be used by sole proprietor directly or can be shared through dividends in case a group of investors owns the commercial property.
Factors Affecting Rental Income:
- First and foremost, the major influencing factor is the occupancy of the commercial property. The higher the occupancy, the higher is the return potential of the investment. Therefore, it is important to strike a balance between the vacant and occupied units to generate a steady-state return
- Another factor influencing the rental income of any CRE investment is the operating expenses. The operating expenses are those compensations that are made by the property owner for reasons such as damage repairments, maintenance expenses, loan payments, and others
Rental income is considered as a passive form of income on a commercial property as there is no active participation of property owners in generating the income. Recently this form of return generation is gaining popularity among investors as it is more simplified and convenient to make a good fortune.
What is the Appreciation Value in Commercial Real Estate Investment?
Over time, the value of an asset changes. It may increase or decrease depending on the status of the economy or trends in the market. The same goes for the value of a CRE property, which can either gain value overtime known as its appreciation value or face depreciation over time. This is where the risky side of CRE investments kick in.
The income from property appreciation cannot be taken for granted as there is no guarantee of gains. The pendulum of the asset rate can swing either way. Your commercial property can gain popularity tomorrow with tenants offering to pay higher rates, or it can decline in value.
Factors Affecting Appreciation Value of CRE Property-
- Availability of land
- The type of marketplace- Primary, Secondary, and Tertiary
- Demand trends in the market
The appreciation value of a commercial property can also be safeguarded by the addition of certain accessory value-adding services such as renovations, furnishings, etc.
How Return Potential of CRE Investment is Evaluated?
After knowing about the sources of returns from a commercial property, the next step is to determine how successful is the return generation rate of CRE property. For this, there are several methods to evaluate the returns, which are discussed below:
Operating Income-
Also known as Net Operating Income or NOI, this refers to the income generated by a commercial real estate property that is arrived at after removing the operating expenses and debt service charges from the total returns. The operating income is the representation of the cash flow through the asset barring the costs which have been incurred during a period of leasing. It should be noted that the net operating income of any asset is an essential determinant of the profitability of an investment.
IRR-
Another method of evaluating the potential returns is through the calculation of the Internal Rate of Return or IRR. The internal rate of return of any investment determines its capability of being profitable in the future based on the current performance. The ideal internal rate of return of a business occurs when the net present value is equal to zero, i.e., the net cash inflow equals cash outflow. IRR helps in the projection of the investment returns in the future.
Cap Rate-
The Cap rate or Capitalization rate of a commercial real estate property refers to an analysis of the total returns earned over an investment without excluding the expenses made or debt on the property. Expressed as a percentage value, the cap rate of a CRE property gives a clue about the returns provided by a CRE investment over the estimated income. It is the most popular method used for the evaluation of CRE investments.
All these above methods contribute to determining whether the current investment is proving fruitful to the investor or if any investment to be made will be successful or not. The evaluation of a CRE investment is vital to avoid financial losses or economic draining.
CRE Metrics FAQs:
Generally, a 10% rate of return on a CRE investment is considered profitable on a long-term basis. However, other factors, such as the size and location of the property come into play while considering the rate of returns.
A commercial real estate commission is essentially the fee paid to a commercial real estate agent after the procurement of a CRE property.
Tenant improvements refer to the alterations or modifications made by the tenant to the property on rent for business purposes. Depending on the agreement under the lease clauses, either the tenant or the building owner pays for the tenant improvements.
The commission earned by a commercial real estate agent is negotiable by the property owner and investor. The current commission rate of the agent is about 3% to 10%.
