Return on real estate
Return on real estate consists of direct and indirect components. Understanding both elements is essential for professional real estate investment.
Components of real estate returns
Direct return
Direct returns on real estate arise from net (rental) income after deducting operating, financing and fund expenses. Commercial real estate has varying direct returns depending on location, property quality and market conditions.
Indirect returns
Value development constitutes the indirect return. This component is realized upon sale and depends on market trends, location dynamics and object-specific factors.
Total Return
Total return is the sum of the direct return and the indirect return and is achieved only after you sell. The combination and ratio of the direct and indirect returns say something about the return/risk profile of the investment.
Calculate returns
Calculating the return on real estate starts with the gross initial yield freehold: annual rent divided by total investment including acquisition costs. This percentage gives a first indication of the direct return, but does not tell the complete story.
For the net return, all operating costs are then deducted. Maintenance, management, insurance and local taxes substantially reduce the gross return. This net return determines the actual cash flow generated from the property. The difference between gross and net can be significant, depending on the intensity of management and the condition of the property.
The total return from investing in real estate combines direct rental income with expected value growth. This total return calculation requires assumptions about future value growth and exit scenarios, making it inherently less certain than the direct return. Professional investors therefore use different scenarios to determine the range of possible outcomes.
Determinants of real estate returns
Location determines the return potential of real estate. Properties in economically strong regions with limited new construction opportunities perform structurally differently than properties in shrinking areas. This location quality has a direct effect on both rents and value growth.
In addition, contract quality plays an essential role. Long-term leases with solid parties provide stable income, with the initial yield often reflecting the perceived risk profile of tenant and contract. Financing structure is also important: The ratio of rental yield to financing cost determines the effectiveness of leverage, with conservative financing providing protection against interest rate volatility.
In operational real estate, the real estate itself is the source of operating income. A parking garage earns from parking transactions, a hotel from room rentals. This differs from offices, where tenants earn their revenue elsewhere. These differences determine the contract structure and return profile.
Fixed-rent leases offer stable income because the operator bears the operational risk. With management agreements, the risk lies with the owner, which can generate higher returns. Operator quality directly affects returns: expertise, systems and market position generate difference in operational performance.
Risk and return
Average property returns vary with risk profile. 'Prime' properties have lower volatility but also more moderate returns and higher liquidity. Secondary locations may offer higher initial yields because of a higher perception of risk.
Diversification across geographies, sectors and tenant profiles stabilizes portfolio returns. Concentration risk in one segment increases the volatility of total returns.
Market cycles affect both direct and indirect returns. Long-term investors can average out cycles; short-term strategies require active timing.
Access structures for real estate returns
Direct property acquisitions require substantial capital, often several million for a single property. This concentration in a single property, location and tenant can increase the risk profile, despite full control of the property.
Fund investing offers an alternative with lower entry thresholds and provides opportunities for direct diversification. Professional management, quarterly reports and risk diversification across multiple properties characterize this form of investment. Minimum participation varies by fund but is generally substantially lower than direct purchase.
Orange IM specializes in operational real estate combining real estate expertise with operational knowledge. The Orange IM Parking Fund I illustrates this strategy with the Sint Jorisplein parking garage in Amersfoort, operated by Q-Park. The fund structure makes institutional real estate quality accessible from €100,000.
Frequently asked questions about real estate returns
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The formula is: gross initial yield freehold = (year 1 rental income / total purchase price (including costs)) x 100
For a complete picture, include operating and financing costs. Professionals do extensive scenario analyses, but this basis gives a good first indication.
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Parking garages on the edge of inner cities combine growing scarcity with stable demand. They benefit from yield management, have easily planable maintenance costs and are relatively crisis-proof.
Ready for professional real estate returns?
We enjoy sharing our expertise on yield and real estate investment. Orange IM provides access to institutional operating real estate with an attractive yield profile.
