One of the best investments we can make is in our own knowledge and skill set. With that in mind we can use Return on Equity to better understand investing in Commercial Real Estate (CRE).
Return on Equity
Return on Equity (ROE) is a financial metric that measures the profitability of an investment relative to the equity invested in it. In the context of commercial real estate, ROE is a critical measure for evaluating the performance of a property investment. To calculate ROE in commercial real estate, follow these steps:
- Gather Financial Data: Obtain all the necessary financial data related to the commercial property investment. This typically includes:
- Net Operating Income (NOI): This is the property’s annual rental income minus all operating expenses (property taxes, insurance, maintenance, etc.).
- Property Value: The current market value of the commercial property.
- Equity Invested: The amount of your own money that you’ve invested in the property, often calculated as the purchase price minus any financing (e.g., mortgage) you’ve obtained.
- Calculate Return On Equity: Use the following formula to calculate ROE:ROE = (Net Operating Income / Equity Invested) × 100
- Net Operating Income (NOI) is used in the numerator because it represents the property’s earnings before debt service.
- Equity Invested is used in the denominator because it reflects the portion of the property’s value that you own outright (i.e., your own money).
- Interpret the ROE: Once you have calculated the ROE, you can interpret the result. A higher ROE indicates a more profitable investment relative to the equity you’ve invested. Conversely, a lower ROE suggests that the investment may not be as profitable or efficient in utilizing your equity.
Keep in mind that commercial real estate investments can be leveraged (financed with debt), and the ROE calculation focuses on the equity portion of the investment. Leveraging can amplify returns when the property appreciates in value but can also increase risk, particularly if the property’s income does not cover debt service.
It’s essential to consider other factors, such as market conditions, location, property type, and your investment goals, when evaluating a commercial real estate investment. Calculate Return on Equity should be used in conjunction with other financial metrics and qualitative analysis to make informed investment decisions. Additionally, remember that commercial real estate investment involves risks, and it’s advisable to consult with financial professionals or real estate experts before making significant investment decisions.
