What is Real Estate Investment Payback Period?
The Real Estate Investment Payback Period is the time required on an investment to generate enough money to recoup the original cost.
- What is Real Estate Investment Payback Period?
- How to Calculate Real Estate Investment Payback Period
- Real Estate Investment Payback Period Formula
- What is a Good Payback Period in Real Estate Investing?
- Real Estate Investment Payback Period Calculator
- 1. Commercial Real Estate (CRE) Property Assumptions
- 2. Real Estate Investment Payback Period Calculation Example
How to Calculate Real Estate Investment Payback Period
The real estate investment payback period measures the time between the date of initial purchase and the date on which the break-even point is met.
In the context of commercial real estate (CRE) investing, the real estate investment payback period is the estimated time necessary for the cumulative rental income of the investment property to match the original purchase price.
The break-even point (BEP) in real estate investing refers to the state at which a property’s annual return is equal to the original purchase price (or current property value).
Conceptually, the real estate payback period measures the recovery time in which the investment property remains unprofitable (and thus operates at a loss).
Since the total rental income and cost are equivalent at the break-even point, the investment property is, at that point, generating neither a profit nor a loss.
The rental income produced beyond the break-even point represents “excess” profits for the property owner (or real estate investor), i.e. the yield on the investment is then net-positive.
The process to calculate the real estate investment payback period consists of three steps:
- Calculate Total Cost of Investment → The sum of the purchase cost, including closing costs, renovation costs, and fees paid for professional services (e.g. appraiser, real estate agent).
- Determine Annual Return on Investment Property → The cap rate on the investment property is divided by the total property value (or sale price, inclusive of adjustments for other fees).
- Estimate the Real Estate Investment Payback Period → The number of years to break-even is the total investment cost divided by the annual return in gross terms.
Real Estate Investment Payback Period Formula
The real estate investment payback period, or the number of years required to break-even, is calculated by dividing the total investment cost by the annual income expected to be generated per year.
Where:
- Property Value → The property value, or total cost, is the total spend while completing the property investment, including the direct property-level expenses incurred across the holding period.
- Annual Return → The annual yield on the investment property multiplied by the property value at present.
The calculation output will be expressed in terms of the number of years.
Therefore, a payback period of ten years indicates that the real estate property investment will break-even and start to produce a profit after ten years.
There is no standardized method for calculating the metric, as the context of the analysis determines which costs to include (or exclude).
For instance, when estimating the time required to break-even on an investment on an individual basis, it is far more common to include additional discretionary adjustments compared to when performing a break-even analysis to compare the property against an industry benchmark set by comparable properties (i.e. “apples-to-apples”).
Note: The property types for which the payback period is analyzed are usually acquisitions of stabilized (or near stabilization) properties, such as core or value-add investments, rather than for development projects.
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Enroll TodayWhat is a Good Payback Period in Real Estate Investing?
Considering the real estate investment payback period determines the time – expressed in the number of years – until a particular investment reaches its break-even point, most investors prefer to recoup (and de-risk) their investment as swiftly (i.e. in as short of time) as possible.
However, the strategy of the real estate investor must be accounted for, as each individual investor has its own unique style of investing, risk-return profile, and hold period preferences.
There is merit to the notion that a shorter real estate investment payback period coincides with higher returns (and less risk), assuming the selected peer group of properties are comparable.
In short, the faster the investment can break-even and start to turn a profit (and generate a positive return), the more likely the investor is to meet or surpass their minimum rate of return, or “hurdle rate”.
Real Estate Investment Payback Period Calculator
We’ll now move to a modeling exercise, which you can access by filling out the form below.
1. Commercial Real Estate (CRE) Property Assumptions
Suppose a commercial real estate (CRE) investment firm is performing diligence on a potential investment opportunity.
The commercial office building is stabilized and expected to generate $2.5 million in annual net operating income (NOI) post-acquisition.
The market value of the property is priced at $20 million at present, which is the sale price at which the purchase is anticipated to occur.
- Stabilized Net Operating Income (NOI) = $2.5 million
- Property Value (or Total Cost) = $20 million
For the sake of simplicity, we’ll implicitly assume that the relevant direct property-level costs were accounted for in the stabilized NOI metric, and the property value is interchangeable with the total cost.
The property value formula can be rearranged to solve the implied cap rate, which is 12.5% here.
- Property Value = Net Operating Income (NOI) ÷ Cap Rate (%)
- $20 million = $2.5 million ÷ Cap Rate (%)
- Cap Rate (%) = $2.5 million ÷ $20 million = 12.5%
2. Real Estate Investment Payback Period Calculation Example
Given those assumptions in our hypothetical scenario, what is the implied payback period on the commercial real estate investment?
While the stabilized net operating income (NOI) and current property value were provided as assumptions, we’ll manually calculate the property value to further reinforce the NOI multiple concept in our exercise.
In effect, the cap rate can be perceived as the inverse of a multiple.
The annual NOI of a property investment can be divided by the corresponding cap rate or multiplied by its equivalent NOI multiple.
The outcome under either method is the same, as we’ll shortly illustrate.
- Property Value = Net Operating Income (NOI) ÷ Cap Rate (%)
- Property Value = Net Operating Income (NOI) × NOI Multiple
The NOI multiple is 8.0x, which we determined by dividing the property value by its stabilized net operating income (NOI).
- NOI Multiple = $20 million ÷ $2.5 million = 8.0x
If we multiply the NOI multiple by the stabilized NOI, we arrive at a property value of $20 million, which matches our initial assumption.
- Property Value = 8.0x × $2.5 million = $20 million
Since the numerator – the property value (or total sale price) – has now been determined, the next step is to calculate the annual return.
The annual return is the cap rate multiplied by the property value, which is $2.5 million per year.
- Annual Return = 12.5% × $20 million = $2.5 million
In the final step, the real estate investment payback period can be estimated by dividing the property value by the annual return, which implies that the time required by the commercial property to reach its break-even point and start generating a profit is approximately 8 years.
- Investment Payback Period = $20 million ÷ $2.5 million = 8.0 Years
Given the annual return of $2.5 million, it should be relatively intuitive that after eight years, the cumulative return retrieved to date amounts to $20 million.
Therefore, the commercial real estate (CRE) firm has recouped the full amount of the original capital contribution, and the investment is now starting to generate positive returns on behalf of the fund.
