Real Estate Investment Payback Period

What 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.

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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.