How is commercial real estate rate of return calculated?
The rate of return relates to the actual cash on cash return on investment (ROI) of a property, which is net income divided by the amount of money invested. The less money an investor has invested in a property, the better opportunity they have for an increased rate of return.
For example, if an investor buys an apartment complex for $1.5 million, putting $300,000 (20%) down, and collects an annual NOI of $36,000, their ROI or rate of return would be 12% annually.
Now let's say they were able to get a loan putting only $225,000 (15%) down, still collecting $36,000 a year. Their rate of return would jump to 16% simply because they had less cash invested.
How can you boost your commercial real estate rate of return?
By far the best way to boost your rate of return is to put the least amount of money down as possible. However, there are other ways to boost your rate of return after the property has been purchased.
An investor can also increase their rate of return by increasing the net operating income or rental income received each month. If the investor buys the property in the example above with 20% down but increases the annual NOI to $45,000, they've increased their rate of return to 15%.
The six strategies below are different ways you can boost a commercial property's rate of return in one of two ways:
- By increasing the net operating income (or net cash flow) while holding the property.
- By increasing the rate of return when selling the property by increasing the property's value.
1. Decrease vacancy
When a rental property sits vacant, it loses money. Decreasing a property's vacancy rate will increase your net operating income because you're increasing the number of units or the amount of time the property is collecting rental income.
Most CRE sectors have a standard or average vacancy rate based on the property type and location. So while a 0% vacancy may be appealing, it's rarely achieved when charging market rents.
2. Increase rents
While every investor should aim to keep vacancy rates low, they should also strive to keep rents at or near market standards. Some investors, especially if the property is charging below-market rents, have the opportunity to strategically and incrementally increase rents. Nonetheless, rental increases should be done on a regular basis to match inflation and reflect changes in property-related costs such as property insurance, utility costs, or property taxes.
If your property has 100 units and you increase rents by just $15 each, you would have increased your rental income by $1,500 each month, or $18,000 a year. This can significantly boost your rate of return while you hold the property.
3. Decrease expenses
Keeping expenses low is extremely helpful when trying to boost your rate of return. While not always feasible, there may be opportunities to decrease certain expenses, especially after acquiring a property that may have been poorly managed previously. For example, you can utilize management tools such as property management software to streamline rent collection, leasing, and contractor management, reducing the amount you need to pay for an on-site manager at the property.
4. Add additional streams of revenue
Creating additional streams of revenue can be a great option for helping boost your rate of return, especially in conjunction with the other strategies referenced here. Common additional revenues can include:
- Charging rental fees for additional space, such as parking or garage space.
- Collecting late fees.
- Selling goods or inventory, such as moving boxes or locks.
- Collecting monthly pet rent (if allowed by state).
5. Improve the property
While improving the property may not always increase your rate of return, strategic improvements can add value to the the property overall and allow for you to justify increased rents or help with getting new tenants. Installing new energy-efficient windows or air conditioning units could reduce your overall utility expense and increase your return. Adding a green space for pets to use the bathroom or a path for tenants to walk their dogs adds value and amenities for your tenants that may place your rental space over another at a comparable rental rate.
If your property is currently performing to market standards, another option is to expand your property, adding more rental units. While this is not always an option, some investors target properties that have additional land solely for the opportunity to expand and add additional units, buildings, or rental space.
If you originally purchased a property that produced $36,000 in annual net income but added another building with an additional $36,000 in rental income, you've now increased your property value and rate of return significantly.
The bottom line when real estate investing is to get the greatest possible return. By utilizing these six strategies, you can potentially increase your rate of return and boost the investment as a whole.