Everybody wants to get the most “bang for their buck.” Commercial real estate investors are no different. They want properties that make money. In this article, we explore Return on Investment (ROI) and property value. We also discuss factors that influence investors’ decisions, both now and in the future.
What is Return on Investment?
ROI = (Gain from Investment – Cost of Investment) / Cost of Investment
This formula is simple, however, investors should consider a number of factors when calculating the cost of investment. Maintenance costs, leverage (money borrowed with interest to invest in a property), and the size of the investment all affect the cost.
Essentially, a property’s return on investment shows determines the profit as a percentage of the overall building cost. Knowing your property’s ROI indicates how effectively the property rents available space, manages overall maintenance costs, and utilizes property management services. For commercial real estate, the ROI can also impact the overall property value.
A good commercial real estate broker will help determine your property’s return on investment.
How to Maximize ROI
There are a number of ways to maximize ROI. First, you can purchase less expensive investment properties. Second, invest in improvements that will increase your property’s desirability, increase occupancy, and therefore increase property value. Finally, reduce your overall costs by examining your expenditures.
Purchase Less Expensive Investment Properties
The best way to maximize your return on investment is to purchase a property for the lowest possible price. You will calculate your overall ROI based on this purchase price and all associated fees or debts. Therefore, working with an experienced broker to get the best property at the lowest rate will be the easiest way to increase ROI over time.
Before investing, buyers should fully understand the local market and the average returns for similar assets in the area. Similarly, commercial real estate investors should conduct due diligence to determine which properties have the most potential for larger returns.
Some lower-priced properties may need significant renovations or repairs. However, if the price is right, these investments could lead to increase property value and increased ROI over time, making it worth the cost.
Investors who already own property might consider refinancing as a way to lower annual costs and increase ROI.
Invest in Improvements (and Boost Property Value)
The next step to improving your ROI is to increase occupancy rates and increase your property value. We’ve talked about property value before (read more about it here). The basic concept is that by making improvements to your property, you will make your building more attractive to high-paying tenants. Therefore, you will increase occupancy rates, increase monthly income, and increase your overall property value. Each of these factors can impact your return on investment.
We explore improvements below – particularly those that can prevent your property from becoming obsolete. However, in today’s market, technological improvements can both increase your building’s property value and decrease your overall expenditures. Installing smart tech options throughout the building can help lower energy costs, or eliminate costly repairs. Real estate technology is helping property owners and property managers lower their expenses, raise property values, and increase their return on investment.
Conversely, a newer property which needs fewer updates and less ongoing maintenance may have a higher price tag, but a lower overall costs.
Reduce Annual Costs
Reducing your annual costs can greatly improve ROI. Take a close look at your property’s overall expenditures – from interest on debt payments to property management costs – and determine where you can make cuts. Sometimes, installing technology can improve your building’s functionality, helping reduce operations and maintenance costs. Hiring an efficient property management team can also help reduce your annual costs, helping you realize greater profit over time.
ROI and Building Obsolescence
Apart from the factors listed above, there are other elements that affect ROI. In reference to commercial real estate, obsolescence is defined as a reason why a property’s value decreases. Below are three types of obsolescence which directly impact ROI:
- Physical obsolescence – The age of a building or structure along with physical wear and tear.
- Functional obsolescence – Design flaws, inadequacies in the construction, outdated technical components, or outdated technologies.
- Economic obsolescence – Factors outside of the property itself, including neighborhood decline. These issues can lower the property value or make it more difficult to conduct business.
Changes in Technology and Consumer Behavior
Along with obsolescence, there are additional factors that may impact commercial property investments. In the next two decades, these factors could fundamentally change the face of commercial real estate and the way investors choose properties.
In an article entitled, “ROI Falls to the Investor who Understands Building Obsolescence”, Joseph P. Derhake (CEO of Partner Engineering and Science Inc.) lays out emerging factors which will affect ROI in the near future. Three of these are outlined below:
- Autonomous vehicles – Changing transportation trends will affect commercial real estate investors. Specifically, driverless cars will change how people use roadways, public transportation, and vehicle-related infrastructures like gas stations and parking facilities. These changes will also influence how employees arrive to work in the future. They will affect entryways, car-related facilities, and potentially urban planning itself. In the future, the overall layouts of city streets could change completely. This is an important consideration for investors in office properties, both in urban and suburban areas.
- Online shopping – Rapid changes in the retail sector affects commercial real estate investors as well. With the rise of eCommerce, specifically during the COVID-19 pandemic, retail stores are becoming increasingly obsolete. In addition, next-day and same-day delivery are more common than ever before. This puts pressure on distribution centers to evolve and adapt to avoid obsolescence.
- Online banking – Banks are becoming consultation spaces rather than full-service banks. Customers who pay bills, transfer money, and even deposit checks via mobile phones don’t need to access a teller. Therefore, demand for brick-and-mortar banks will continue to delcine. Future banks will be smaller, but will also need to be in prime locations.
The Future of Real Estate Investing
As commercial real estate investors look towards the future, they must consider changes in technology, workers’ commuting habits, and evolving consumer behavior. These factors will influence the development, construction, and maintenance of properties and directly affect the return on investment into the future.