In commercial real estate, return on assets (ROA) helps investors evaluate whether a property and its assets are being utilized to their full profit-generating potential.
In this guide, you’ll get an idea of how ROA can help you with your property investments. We’ll show you how to work it out using the ROA formula, unpack some of the benefits and limitations, and explore some real-world examples.
What is ROA?
ROA is a financial metric that offers insights into the profitability of a commercial property in relation to the total value of assets involved.
It tells us how efficiently a property is being used to create profit, by providing a measure of how much profit each dollar of asset value generates.
The ROA formula sets itself apart from other common metrics such as ‘return on equity’ (ROE) which assesses the equity growth, and ‘return on investment’ (ROI), which focuses on return from the initial capital outlay.
ROA is calculated by dividing a property's net income by its total assets. It’s expressed as a percentage.
The ROA Formula
The ROA formula has two components: net income and total assets.
Net income is the profit that a property generates after accounting for all operational expenses and taxes.
First calculate gross income, which might include rental income and any other revenue streams tied to the property. Then subtract all the costs related to operating and maintaining the property, as well as taxes owed. The result is your net income.
Total assets include all items of value. In the context of a commercial property, total assets include the property's market value and any other associated assets. Total assets could consist of:
• The property – building/s and land
• Equipment or machinery
• Any property improvements or capital expenditures
How to Calculate ROA
Use the formula below to calculate ROA:
ROA = Net Income / Total Assets
Now multiply this ratio by 100 to get the percentage.
A warehouse property generates a net income of $100,000. This property’s total assets include its market value and some manufacturing machinery and equipment. The total assets amount to $1,000,000. The ROA of the property would be:
ROA = $100,000 / $1,000,000
= 0.10 x 100
In other words, each dollar spent on the property assets, is generating a return of 10%
Factors Affecting ROA
Several key factors can affect your ROA in commercial real estate:
Conditions of the CRE property market in your property’s location, and also in the greater economy, can affect your property’s market value.
For example, shifts in interest rates affect supply and demand, which in turn sees changes in property values. The type of property you own (such as retail, office or multifamily) will also be subject to differing market conditions.
As property value has a direct impact on your total assets figure, which in turn affects ROA, it goes without saying that good/poor market conditions will influence your returns.
While market conditions are not something within the direct control of the property owner or investor, it’s still very important to keep up to date with what’s happening in your local area.
Market conditions are out of a property owner’s control, but property maintenance isn’t. A well-maintained property will have a higher property value which will influence the ROA.
Your maintenance protocol should involve regular inspections to ensure that no issues are undetected for a lengthy period. You might also consider strategic upgrades or additions to your property to enhance its value.
These might include adding energy-efficient features or modernizing communal areas. Take care not to over-capitalize on improvements, as the costs may outweigh the potential income benefits.
A well-maintained property is also more likely to attract and retain high-quality tenants, which are essential to consistent CRE income.
Property Management & Operational Efficiency
Effective property management ensures maintenance is carried out timeously, rent is collected on time, vacant units are filled up quickly, and more.
Good property managers help property owners and investors keep a tight ship on their property’s income, management, and operational costs. Thereby optimizing the net income and having a direct effect on the ROA.
For example, a poorly managed property might have vacancies more often and for longer periods of time, than a well-managed one. The same property might lose good tenants due to maintenance issues not being dealt with timeously. These factors will clearly have a negative effect on profitability.
Understanding and managing how these variables influence your ROA helps investors to strategically monitor and adjust accordingly.
Interpreting ROA in Commercial Real Estate
ROA is often used in the business world to measure a company’s financial health.
Typically, a ‘good’ ROA for a company could be anything between 5% and 20%.
You might find that a company in one sector, such as an industrial manufacturer, has several expensive assets leading to a lower ROA.
A tech company that produces an app with very few overheads, on the other hand, has a higher ROA.
You’d only know whether each company’s ROA was ‘good’ or ‘bad’ if you compared it to other similar companies in the same sector, not to each other. The same goes for using ROA in commercial real estate.
A higher ROA would usually be considered better because it means that the property is generating more income per dollar spent on assets, but when compared to another property of the same type in the same location, its ROA could actually be below average. You’ll only know the answer by comparing the trends across the specific market sector.
A ‘good’ ROA is subjective and may change depending on individual investment goals and strategies.
Generally speaking, however, any ROA above 5% might be considered ‘good’, and a negative ROA should be deemed a red flag that the property has some serious areas for improvement.
The trends of your property’s ROA should also be looked at regularly. If you see the ROA consistently decreasing over time it might indicate an operational issue that needs to be fixed.
It could also be the result of a declining property market in your sector. Analyzing the trends helps you to remain agile so you can adjust your strategy before it affects the bottom line too deeply.
Lastly, while ROA is an incredibly useful metric for CRE investors to compare apples with apples, it is only one of many metrics, so should never be used in isolation.
Comparing ROA with Other Investment Metrics
ROA can be used alongside other CRE metrics to evaluate investment opportunities and make informed decisions. You might be wondering how these metrics differ:
ROA vs ROI
ROI measures the profit made per dollar spent on the initial property purchase, without considering other assets such as machinery or equipment.
This fundamental difference can significantly impact an investor's decision, as ROI could give a skewed picture of profitability for properties that have significant income-generating assets aside from the property itself.
ROA vs ROE
While ROA provides insight into profitability relative to all assets, ROE reveals the return per dollar of equity, offering insight into profitability after accounting for liabilities. The key difference lies in the consideration of debt.
ROA vs Cap Rate
ROA measures the actual profit a property generates relative to its assets, whereas cap rate indicates potential profitability based on projected earnings. The fundamental distinction here is the difference between actual and potential profitability.
ROA vs Cash-on-Cash Return
Cash-on-cash return calculates the ratio of net cash flow to total cash (equity) invested. Unlike ROA, it doesn’t take current market value or additional assets into account. The crucial difference is in the consideration of cash flows rather than net income.
Use-case Scenarios: Applying ROA in Real-World Scenarios
Some real-world scenarios where commercial real estate investors might use ROA include:
Property Portfolio Analysis
Investors with a portfolio of properties can use ROA as a measure to compare how well each property is generating income. A decreasing ROA might point to operational inefficiencies that need to be addressed.
Property Value Enhancement
A low ROA can be improved by upgrading a property to increase its revenue-generating potential. Investors might calculate the ROA before and after the renovations to assess whether their investment is achieving the desired return.
A consistently declining ROA, despite best efforts to improve it, might be a sign that it’s time to sell a property, and invest in something else more profitable.
Market and Location Analysis
An investor might use ROA to compare the profitability of different investment properties across different property types (office buildings, shopping malls, or warehouses), and also across different geographic locations. A higher ROA would generally indicate a better investment opportunity.
Limitations of ROA
ROA is a powerful metric but it’s only a small piece of the commercial real estate puzzle. It has a few drawbacks such as overlooking factors like location quality, tenant quality, and market risks.
ROA doesn’t take financing into account which means that two properties with similar ROAs might have drastically different levels of debt. Property A, having a high level of debt but a strong cash flow, could have the same ROA as Property B, which has minimal debt but lower cash flow.
Without considering the debt level, ROA could give a misleading picture of profitability.
Similarly, because property values fluctuate over time, comparing ROAs of different properties or the same property over time can be challenging.
For example, a property purchased during a market dip might have a higher ROA than a similar property purchased at the market's peak, even if their operational incomes are the same. Thus, ROA should always be looked at in conjunction with other ROI metrics, to get an accurate big picture.
Final Thoughts on the ROA Formula
The ROA formula is useful for assessing a commercial property’s income-generating ability, albeit with certain limitations. These limitations can be offset by using more than one metric to gain a comprehensive picture of a property’s profitability.
A robust CRE investment strategy should involve assessing ROI metrics along with the greater market context, to maintain a big picture view. A CRE location insights platform, like AlphaMap, equips you with a toolkit of analytical features that simplify the complex decisions of commercial real estate, ensuring you stay ahead of the competition.