ROI vs profit
With our focus surrounding the average yield on a commercial property and ROI, it can be easy to confuse such metrics with total profit. Remember, the profit generated (monthly expenses deducted from income) is a crucial element within the ROI and cap rate formula (see above).
Profit is also traditionally used to describe the remaining capital gains from sold properties. As an asset, a sale incurs capital gains or losses once subtracting the property’s original out-of-pocket expenses from the selling price. On the other hand, your current commercial property yields are a measurement to evaluate ongoing cash flow.
You can always try our rental yield calculator to get a full breakdown of your growth potential in just a few easy steps.
How do you calculate ROI?
The formula to determine ROI on commercial property returns is:
ROI = (Investment Gain – Investment Cost) / Cost of Investment
For example, say an investor purchases a commercial property worth $1,000,000 with a down payment of $200,000. Closing costs totalled $10,000, with further remodelling expenses at $50,000.
Total out-of-pocket expenses are therefore $260,000 ($200,000 + $10,000 + $50,000).
Monthly expenses are principal & interest payments on the mortgage of $4,500 and an additional $2,000 to cover insurance, taxes and other miscellaneous expenses.
Total monthly payments are therefore $6,500 ($4,500 + $2,000).
Finally, earnings are $10,000 per month in rental income.
To calculate ROI, the formula would be:
ROI = [($10,000 x 12 months) – ($6,500 x 12 months)] / $260,000
ROI = ($120,000 – $78,000) / $260,000
ROI = 0.1615 or 16.15%
Ways to improve ROI on commercial real estate
From optimising rental increments and minimising vacancies to streamlining overhead costs and improving amenities, wise investors can employ various strategies to improve their commercial property returns.
Rental increments
Striking the right balance between rental rates to attract tenants and promoting healthy commercial property returns can be challenging. Whilst offering incentives, such as discounted periods, might be tempting to overcome the competition of other properties on the market, this can prove counterproductive. Inflation, taxes, rising utility costs and other macroeconomic fundamentals will erode your ROI if rental rates remain low or stagnant.
It helps to have a firm understanding of the broader real estate market and the average yield on similar commercial properties to help you set your rental rates at the appropriate levels.
Avoid vacancies
Without tenants submitting regular instalments of rental income, property owners are actively losing money, given the range of monthly expenses that still exist, such as loan repayments and maintenance costs. As such, a simple method to improve current commercial property yields is to minimise vacancy periods.
Doing so requires efforts to prolong tenancies and refine marketing campaigns to shorten transitionary periods. For example, it helps to maintain ongoing communication with tenants to understand whether they will continue their tenancy once a lease expires. If they are due to vacate, property owners can swiftly put in place advertisem*nts to find suitable replacement tenants without any downtime.
Minimise overhead costs
Minimising overhead costs can also help improve ROI on commercial properties by reducing the amount of money you have to spend each period on areas like repairs, maintenance, and utility bills.
Excellent methods for reducing overheads include:
• Refinancing your mortgage to take advantage of lower interest rates
• Shopping around for property maintenance & management services offering the best rates, without sacrificing quality
• Shifting between utility providers or even negotiating with tenants to cover utility expenses within their rental payments
• Introducing energy-efficient building practices and technology, helping to save on your monthly utility bills
Make improvements as necessary
Commercial real estate can rapidly lose value when falling into various forms of obsolescence. Whether it be physical wear and tear, outdated components and design flaws, or a decline in the surrounding geographical area, making improvements to keep your site competitive is crucial in improving your current commercial property yields.
For example, installing modern features like state-of-the-art security systems or updating fixtures and appliances as needed can lead to capital growth and ensure your property stays attractive to potential tenants. Even expanding onto unused land could work to accommodate tenants with larger operational demands, creating an opportunity for rental growth.
