How Do Returns Work on Commercial Real Estate?

Commercial real estate investments generate returns in two possible ways: rental income and property appreciation.

Rental Income

Rental income is generated by renting to a tenant or multiple tenants. This rental income becomes cash flow or revenue for the equity owner(s) of the property, aka a cap rate. For commercial real estate investments offered through addy, this income reaches the hands of investors in the form of distributions paid out annually or at the end of the investment term (exact details vary by the investment property).

Factors impacting cash flow

Commercial real estate’s ability to generate cash flow depends on a number of other factors, such as operating expenses and debt service. Property landlord duties can include maintenance and repairs, loan interest payments, rent collection, evictions, finding tenants, and ensuring that the property is compliant with all applicable laws at all times. 

Passive income

The income produced by rental payments is often considered passive income for the owner, depending on how they’ve decided to establish their management of operations at the building. While some real estate investors like to be fairly hands-on, others prefer to delegate operational responsibilities to property managers. addy is a truly hands-off real investment vehicle offering passive income potential while putting no property-level management responsibilities on you.

Appreciation

Although not guaranteed, another avenue to generate returns and profitability of a commercial real estate investment comes from any increase in the property’s equity value – or appreciation – over the period of ownership. It’s important to remember that depending on certain economic factors, some properties may also depreciate and that this return would only be realized at the sale of the property.

In general, real estate is a unique and scarce asset class. More raw land can’t simply be “created” especially in hot real estate markets like the Lower Mainland and Fraser Valley. This scarcity is increased by demand as many renters experience in major cities. If demand increases for your property, or in the area near your property, there’s a good chance that tenants will be willing to pay higher rents, and prospective buyers will be willing to pay a higher price than you paid originally to buy it from you.

In addition, scarcity often depends on the particular marketplace in question. In general, a supply-constrained housing market in an urban center will value a new commercial building more highly than a rural area with a marketplace where housing is plentiful. The scarcity of a hard asset and corresponding property values can vary massively from one postal code to another. These different markets are often referred to as primary, secondary, or tertiary:

  • Primary Market: Generally refers to the center of a major metropolitan zone, where populations are dense and economic activity is high (e.g. Vancouver), these markets typically have the most expensive real estate.
  • Secondary Market: Smaller than primary markets in terms of population and are often the areas surrounding a primary market (e.g. Kelowna)
  • Tertiary Market: Smaller than a secondary market and located even further from a major urban hub (e.g. Salmon Arm). Real estate in these markets is typically even cheaper and in less demand due to the lower population overall.

Adding Value

Appreciation through demand isn’t the only way the value of a property increases. Many investors take an active “value-add” approach to commercial real estate, making improvements to the property to increase its intrinsic value and purchase price, or its ability to earn income during the holding period. Any money spent on property renovations can potentially boost the selling price of the building in the future but remember that while reno’s are underway, the property will likely be empty and not generating rental income.

Other methods might include rezoning an adjacent parcel of land (for example, from residential to multi-family), so that more units can be built. Changing the entitlements and permits available to a piece of land can have a considerable impact on that land’s sale price.

Example

Consider a commercial investment opportunity with a cap rate of 5% where you invest $1,000:

Purchase price $1,000,000
Cap Rate 5%
Your Investment $1,000
% Ownership 0.1%
Expected Annual Return $50
**If the property appreciates, you’d also get a percentage of those gains equivalent to your percent ownership in the property.

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