This content is provided for informational and educational purposes only and does not constitute financial, investment, tax, or legal advice. All investments involve risk, including possible loss of principal. eXp Commercial and its affiliates do not guarantee any investment outcomes or returns. Readers should conduct their own due diligence and consult with qualified financial, legal, and tax professionals before making any investment decisions. The opinions expressed are those of the author(s) and do not necessarily reflect the views of eXp Commercial or its affiliates.
Mastering the numbers is crucial in commercial real estate. Whether you’re scouting a new space or advising a client, understanding key financial metrics helps you look beyond location and lease price to assess long-term value and performance.
Before committing to any opportunity, you’ll need to consider more than just square footage or price per month. You’ll want to evaluate future operating expenses, potential profitability, and how the property stacks up against comparable assets in the market.
That’s where metrics like Net Operating Income (NOI), Capitalization Rate (Cap Rate), and Return on Investment (ROI) come into play. These figures allow professionals to analyze the income-generating potential of a property across all asset types and to compare deals on a consistent, apples-to-apples basis. They also help brokers clearly communicate the financial value of a deal to investors.
So, if you’re planning to dip your toes into commercial real estate, here are the three essential metrics you’ll need to understand to make informed decisions.
ROI: Return on Investment
You’ve likely heard this acronym before. ROI, or Return on Investment, is a widely used metric across industries, but in commercial real estate, it plays a key role in evaluating a property’s profitability. After all, the goal of any investment is to generate income, whether through rental cash flow or property appreciation, so you’ll want to ensure the potential for returns is strong, particularly if you invested a lot into the property.
In its simplest form, ROI is calculated like this:
ROI = (Net Profit ÷ Total Investment) × 100
The higher the ROI percentage, the more profitable the investment. However, calculating ROI isn’t just about subtracting income from expenses. To get an accurate picture, your total investment should include all upfront and ongoing costs, such as:
- Purchase price
- Real estate agent fees and commissions
- Taxes and insurance
- Closing costs
- Maintenance and repairs
- Loan payments (if financed)
To give a clearer picture, here’s an example ROI calculation for a hypothetical commercial property in New York. According to the most recent data from CoStar, the average asking rent for an office space in New York is $59.77 per square foot (PSF), while the average sale price per square foot is $521.
Our formula to calculate a simple ROI for this property would be:
- ROI = Net Profit/ Total Investment x 100
- ($418,390 ÷ $5,210,000) × 100 = ~8.03%
In this example, net profit was calculated by subtracting estimated operating expenses (30%) from the gross rental income:
- $597,700 annual income − $179,310 expenses = $418,390 NOI
This simplified ROI formula is great for quick comparisons across potential investment properties. Keep in mind, this example doesn’t account for vacancy, financing costs, or tax implications. It’s best used as a first-pass calculation to help you quickly assess whether a property is worth a closer look.
NOI: Net Operating Income
NOI, or net operating income, is a calculation used to determine how much profit your property will make. This can help an investor determine whether a property’s potential gains outweigh the costs of maintaining and operating it.
NOI is calculated as follows:
NOI = Revenue Generated – Operating Costs
Revenue generated typically refers to the rental income you receive from tenants, but can also include ancillary income such as parking or advertising. Operating costs will include any administrative and property management fees, repairs and cleaning costs, and insurance.
Let’s say you own a retail property that generates $60,000 in annual rental income. Each year, you spend the following to operate and maintain the property:
- Property management: $4,000
- Repairs and maintenance: $5,000
- Insurance and utilities: $3,000
That brings your total operating expenses to: $12,000
NOI = $60,000 − $12,000 = $48,000
The higher the NOI, the more profitable it is from an operational standpoint. However, since NOI does not consider financing, such as mortgage payments or loan interest, investors must also consider ROI to evaluate the property’s overall return.
ROI and NOI: What’s the Difference?
ROI helps determine what percentage return you will get on your total investment. It indicates whether a property is performing well in relation to its cost, including any associated financing. It also takes into account current market conditions, such as interest rates if you’ve financed the property.
NOI, on the other hand, reflects the property’s income-generating potential. Specifically, it measures rental income minus operating expenses like maintenance, insurance, and property taxes. It does not account for financing, so it is evaluated independently of how the property was purchased.
Simply put, ROI tells you how profitable the investment is for you, the investor, while NOI tells you how profitable the property is as an asset.
Capitalization Rate (Cap Rate)
The capitalization rate, or cap rate, is used to determine a property’s rate of return based on its income relative to its current market value. This helps investors compare the earning potential of different properties or markets.
The cap rate is calculated as follows:
Cap Rate = NOI/ Current Market Value
Let’s say you have a property worth $2,000,0000, and it generates a net operating income of $130,000 a year. Your cap rate formula would be as follows: $130,000/$2,000,000 = 6.5%. A cap rate of 6.5% indicates that the property will generate a 6.5% return on its value annually, assuming stable income and expenses.
However, unlike ROI, the cap rate does not factor in financing costs. Instead, it focuses on the property’s operating performance and current valuation. For instance, if your property has appreciated significantly but income has remained the same, the cap rate will decrease. This isn’t necessarily a bad thing.
A lower cap rate may simply reflect that your property’s value has increased relative to its income. Your property may be in a desirable or low-risk location, where steady appreciation and long-term stability are expected. For many investors, a lower rate of return with greater stability is often preferable to a higher return on a riskier investment.
On the other hand, a higher cap rate can indicate that you’re getting more income relative to the property’s value. While this higher rate of return is good for investors, it may also reflect greater risk. Some investors are comfortable with this trade-off, but it’s essential to weigh both return and risk before making a decision.
When to Use Each Formula — and Why
With so many real estate metrics to consider, it can be difficult to determine which one to use and when. In reality, a savvy investor should consider all three when evaluating a property. Each formula offers a distinct perspective, and understanding when and why to use them can help you make more informed decisions.
To recap:
- Use ROI when you want to know if an investment is worth it based on how much money you’re putting down.
- Use NOI when you need to see how much income a property earns after covering operating expenses
- Use Cap Rate when you want to measure how attractive that income is compared to the property’s overall value