Profitability does not always mean one thing

Profitability, in accordance with the commonly used definition, which can be found, for example, in the “Knowledge Base” on the site higasaclub.pl, is nothing but the Capitalisation Rate Cap Rate or Nominal Cap Rate. It is a key measure in the real estate investment sector. It is the initial return (rate of return) expected by the real estate buyer, expressed as a percentage of the purchase price of the property covered in full with cash. In the following text, we will explain how to make real money on commercial real estate and calculate the profitability of investments.

Let’s start with the formula:

Annual income generated by the real estate, i.e. revenues from rents – fixed costs
÷
transaction price of the real estate

We wrote in detail about the income method and profitability in one of the previous posts. However, the above method is not the only way to calculate the return on investment in commercial real estate.

Similarly, although slightly differently, the rate of return should be calculated if the investor chose one of the possibilities of joint investment in commercial real estate offered by Higasa Properties. In the “Become an investor” option, a calculation according to the following formula is sufficient:

Total interest ÷ amount of capital invested

Depending on the investment selected, the investment period and the rate of return guaranteed by Higasa Properties, we will be able to calculate the rate of return over a period of 6, 12 or 24 months. More on this topic can be found here. 

And how do investment companies calculate the rate of return on investment? In this case, the basis for the profitability assessment is the abovementioned capitalisation rate.

However, almost every entrepreneur specialising in investing in commercial real estate uses the so-called leverage. In other words, it increases its company’s financial capabilities by incurring interest-bearing liabilities. How to calculate the profitability of invested capital in a simplified way in this situation?

Annual income generated by the property – financing costs

÷

amount of capital invested (equity)

This operation looks even better when we calculate it on the example of a commercial property worth PLN 5 million, which has a net profitability of 8%, which means that it generates an annual income of PLN 400 thousand.

What happens if the company decides to spend only PLN 2 million from its own funds and obtains the remaining 3 million from a bank loan, at a cost of 4.5% per annum? In such a situation, the return on equity will increase significantly!

400 000 – (3 000 000 x 4.5%) ÷ 2 000 000 = 13.25%

From a reliable 8%, the rate of return increases to 13.25% per annum! Importantly, the principal cost should not be included in the calculation, only the interest cost. Income from rents, which come as rents from a fully commercialised property, systematically repay the bank liability. Thus, the company’s assets increase in relation to the liabilities held. Net assets increase, without contribution in terms of workload and time, at levels well above 10% per annum.

In other words, if the investor after two years decided to sell the above-mentioned property at exactly the same price at which they bought it, the net profit, which consists of repayment of debt in the bank plus a surplus from rents after the costs of credit, will fall within the range of PLN 500 – 540 thousand depending on the loan period, that is… approx. 25-27% of the initial contribution of PLN 2 million.

If you compare the above calculations, for example, to the current average rates of return on bank deposits (~1.54%), profitability from long-term rental of apartments (~5.02%), or even a 10-year average rate of return on the WIG index (~6.45%), it’s easy to see that the model offered by Higasa Club takes investment to a whole new level.