How to correctly calculate the profitability (real profit) of an investment in commercial real estate: the income method

When searching through countless websites in search of interesting investments related to commercial real estate, we often find slogans that are to draw our attention: 10% investment income, 11% return on the invested capital, real estate yielding 9% income from the day of purchase. Slogans of various content – usually containing a figure that is supposed to be our income per annum. In most cases, without specifying how the magic rate of return for the subject of the advertisement was calculated.

Our company, Higasa Nieruchomości, has often verified ads or proposals for the sale of real estate on the occasion of providing consulting services to our clients. We have dealt with many systems of presenting the “final” customer profit above 10% per annum. The most common case of misleading customers is the total or partial omission of costs associated with commercial real estate. We have also met with an explanation that the presented value of return is a future value if a tenant is found for a vacant (non-rented) part of the premises in the amount of x per m2. The desire to embellish the reality tempts owners and agents who want to sell their real estate at the highest possible price. We have also witnessed rates of return of 6% per annum on commercial real estate, which… also did not include the real estate costs. You should always be careful, not only when the rate of return seems high.

For clarification: there are rented commercial properties on the market with a reliable rate of return above 10% per annum; sometimes the seller suddenly needs cash – different life situations happen, but do not delude yourself… The chance of getting such an offer is close to zero and it usually takes place in a narrow circle of business partners. It is more often the case that commercial real estate is burdened with a greater risk for some reasons, for which a higher rate of return is demanded, e.g. due to its location. There can be many reasons and they deserve a broader discussion on the pages of our blog about commercial real estate. But back to the main topic…

In the case of rented commercial real estate, the correctly calculated rate of return should be based on the income method (in the end, we buy rented commercial real estate for real income, not revenue…).

The formula for calculating the profitability of the invested funds using the income method seems simple:

Yields are calculated using the income method, i.e. (rent – costs) / price

First of all, the assumptions should be made:

According to the income method, we do not include in the calculations:

VAT (We receive payment for the rented area including VAT due to the Tax Office, we only transfer tax to the office, it is not our revenue or cost),
Income tax (Tax cannot be avoided, it will always be there in one form or another and on any profit, even on a bank deposit. There are many forms of taxation as well as tax rates depending on various forms of running business. It is not possible to accept a single rate, and there is also tax optimisation. Each investor must take this variable into account on their own when assessing the profitability of the investment),
External management by a separate entity (You can manage the property yourself, commissioning the service is not mandatory, it is an additional option. The management service may include various aspects that impact the price, the number of properties being managed by the company also translates into the price of the service – this is an individual matter).

Knowing the assumptions (what we do not include in the income method), we can move on to the variables in the formula:

Rents – fixed on a flat-rate basis as a monthly value or per 1 m2 of lease area (there is no doubt when there is access to lease agreements),

Costs – in the case of this variable, we have more room for manoeuvre, because depending on the form of ownership and the type of real estate (freestanding building with a development area above, below 2000 m2 or a separate service and commercial part of a residential building) part of the costs will or will not be incurred.

Costs most often included:

– Real estate tax
– Perpetual usufruct fee
– Rent
– Real estate insurance
– Costs of inspecting the technical condition of the facility (mandatory once or twice a year depending on the area of the facility)
– Common part service (if applicable)
– Service (here, you can include the costs of inspection and service of common parts as the cost per 1m2 of the facility, e.g. from PLN 1 to PLN 3 depending on the size of the facility)
– Fees due to housing communities
– Costs that have been transferred to the tenant in the contract are not included in the calculation of the profitability of the investment using the income method. The lease agreement specifies whether, for example, the costs of utilities, housekeeping work in front of the property (sweeping, snow clearance) are covered by the tenant or the landlord.

Thank you for reading our study and we invite you to follow the next entries on the Blog of Higasa Nieruchomości Sp. z o.o.