Cap Rates for Commercial Real Estate Investors Need to Increase
Everybody wants to get the most ‘bang for their buck’. Commercial real estate investors are no different. They want properties that make money. In this article, we explore ROI (Return on Investment) and give factors which influence investors’ decisions, both now and in the future.
What is ROI?
ROI is the percentage of money invested in a property which an investor keeps after expenses. Investopedia gives the following simple formula for calculating ROI:
ROI = (Gain from Investment – Cost of Investment) / Cost of Investment
This formula is simple, however a number of factors must be considered when calculating the cost of investment. Maintenance costs, leverage (money borrowed with interest to invest in a property) and the size of the investment all affect the cost. A good commercial real estate broker will help with these calculations.
There are a number of ways to maximize ROI, one of which is pursuing a lower cost of investment. Commercial properties which cost more to maintain typically lead to a lower ROI. The opposite is true as well.
For example, an aging, outdated property usually needs more attention and a greater investment over time. Yet at the same time, if the property can be purchased for a lower price, it may be worth the investor’s effort.
Conversely, a newer property which needs fewer updates and less ongoing maintenance may have a higher price tag, but a lower overall costs.
ROI and Building Obsolescence
Apart from the factors listed above, there are other things which also affect ROI. In reference to real estate, obsolescence is defined as a reason why a property’s value decreases. Below are three types of obsolescence which directly impact ROI:
- Physical obsolescence – The age of a building or structure along with physical wear and tear
- Functional obsolescence – Design flaws, inadequacies in the construction, outdated technical components or outdated technologies
- Economic obsolescence – Factors outside of the property itself including neighborhood decline which lowers the property value or makes it more difficult to conduct business
Changes in Technology and Consumer Behavior
Along with obsolescence, there are additional factors which may impact commercial property investments. In the next couple of decades, these factors could fundamentally change the face of commercial real estate and the way investors choose properties.
In a recent article entitled, “ROI Falls to the Investor who Understands Building Obsolescence”,
Joseph P. Derhake (CEO of Partner Engineering and Science Inc.) lays out emerging factors which will affect ROI in the near future. Three of these are outlined below:
- Autonomous vehicles – Changing transportation trends will affect commercial real estate investors. Specifically, driverless cars will change how people use roadways, public transportation and vehicle-related infrastructure like gas stations and parking facilities. These changes will also influence how employees arrive to work in the future. They will affect entryways, car-related facilities and potentially urban planning itself. In the future, the overall layouts of city streets could change completely. This is an important consideration for investors in office properties, both in urban and suburban areas.
- Online shopping – Rapid changes in the retail sector affects commercial real estate investors as well. With the rise of ecommerce, retail stores are quickly becoming showrooms where consumers test out products. In addition, next-day and same-day delivery is more common. This puts pressure on distribution centers to evolve and adapt to avoid obsolescence.
- Online banking – If retail establishments are showrooms for merchandise, banks are becoming consultation spaces rather than full service banks. Customers who pay bills, transfer money and even deposit checks via a mobile phone don’t need to access a teller. There is now less need for large brick and mortar bank buildings. Future banks will be smaller, but will also need to be in prime locations.
The Future of Real Estate Investing
As commercial real estate investors look towards the future, changes in technology, workers’ commuting habits and evolving consumer behavior must be considered. These will influence the development, construction and maintenance of properties and directly affect a property’s ROI.