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Introduction To The Basics of Commercial Real Estate Investments

basics of commercial real estate investments

It is a known fact that Commercial Real Estate Investments render much higher return as compared with other types of investments such as stocks, bonds, forex etc. Real estate not only lets you possess a hard asset with meaningful intrinsic value which increases over time, but it also generates a steady stream of income in the form of rent. It takes a lot of learning to understand the behavior and trends in a certain real estate market, especially when dealing in unregulated markets in Pakistan, however there are certain terms that you must know in order to evaluate your ROI and the property value.

Commercial Real Estate Investments are those whereby you purchase some built-up residential or commercial property to general regular rental income. For example, you can buy a shop, apartment, house, plaza, factory etc., to rent out which generates a regular stream of cash inflows.

Benefits of Investing in Commercial Real Estate

Following are some major benefits of commercial real estate investment:

1- A Stable Source of Regular Income

Commercial real estate earns you hefty amount per month as your regular monthly income. In most cases, it earns you much higher return than stocks & bonds etc.

2- Value Increment Over Time

The value of land and built-up structure will keep increasing over time due to market factors i.e. supply & demand. Even if structure is not well-maintained, but location is good, you can buy the property and do the necessary repairs and renovation work to earn quick return.

3- Pays Back Initial Cash Outflow

Commercial real estate normally pays back the invested amount through cash inflows. Many banks will provide you loan to buy a commercial real estate at some interest rate. If invested wisely, you can earn handsome income as well as own an asset with least equity.

4- Protects You Against Inflation

Normally lease agreements are revised in 10 to 12 months and rent is increased by 5% to 10% per annum which covers the cost of inflation. So, commercial real estate provides you a superior hedge against rising inflation.

5- Pride of Owning a Hard Asset

One major benefit of commercial real estate is that it lets you own a hard asset with high intrinsic value. You feel pride for owning an income generating asset.

After we discussed the benefits of commercial real estate investments, it is important to mention that acquisition cost of a property matters a lot but it is more important to look at the cash inflows and long-term potential of the property.

An an investor, it is very important to understand a few basic terms which are used to evaluate a certain property and assess the pay back period and ROI. If you manage to calculate the precise figures, you will be more likely to make better investment decisions.

Gross Rental Multiplier

First thing is the rent analysis, as to how much rent will be received in a month and the total amount of rent per annum. A quick market survey will tell you exactly how much rent can be expected per month, or if the property is already rented out, you can take that figure.

Property value or price can also be ascertained by quick survey of the area and recent sales of similar properties in that area. We will calculate actual worth of the property below, but for now you can take the final price demanded by the owner. After you have the amount of your gross annual rental income and property price, you can calculate the Gross Rental Multiplier or GRM.

GRM = Property Price/Annual Gross Rent

For example, if the property price is 1 crore, and annual rent amounts to 6 lacs (50 thousands per month), the GRM will be as follows:

GRM = 10,000,000/600,000

GRM = 16.67

It means that it will take 16.67 years for the property to pay back your initial equity. If you know this calculation, you can choose the best options which render higher return. Normally the GRM should be around 10 or less, however in the market like Pakistan, you can take anything less than 12 to be a good option.

Net Operating Income

Second thing is Net Operating Income or NOI, it is the total rental income after expenses. Normally as an owner, you have to spend money for repairs and regular maintenance services of the property, property taxes and home insurance etc. You can also calculate this figure easily as most of the expenses are fixed.

Using the same example above, let’s say your annual expenses will be around 50,000, so your NOI will be as follows:

NOI = Gross Annual Income – Expenses

NOI = 600,000 – 50,000

NOI = 550,000

Capitalization Rate

This NOI is your net annual income from your investment. After you have calculated your NOI, you can easily calculate your Return on Investment (ROI) or Capitalization Rate (Cap Rate).

Cap Rate = NOI/Property Price

Cap Rate = 550,000/10,000,000

Cap Rate = 0.055 or 5.5 %

So, the ROI in this example is 5.5% per annum. If you act wisely, you can increase your Cap Rate up to 8% or above.

Property Value

Taking the same example above, if you know the NOI of a certain property, and average Cap rate for commercial real estate in that specific area, you can easily calculate the property price by using the formula:

Property Price = NOI/Cap Rate

If expect about 7% return on investment, and NOI is 550,000, the property price should be as follows:

Property Price = 550,000/0.07

Property Price = 7857142.85 or approximately 78.5 lacs

In order to increase your NOI, You can consider small commercial units, apartments complex in a sound neighborhood, and similar options where you get more number of income generating units and stable demand for tenancy. You can consider main commercial centers of the city, and search for some B class project in the close neighborhood of some A class expensive projects.

Bad neighborhood doesn’t pay well in rental income, so choose the neighborhood wisely, but you can consider old structures in repairable condition. Do some survey and engage local realtors to find you best deals, take an estimate of the repair cost and above-mentioned terms, and you will finally strike a much better deal which saves you ample cost, and earns you better ROI.

Now you can do your homework in a better way according to your budgets, source of funding, and investment targets before going into any commercial transaction. We hope that our endeavors will help you make your investment decisions safely, and let you focus on the important aspects of commercial real estate investments.

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