The main goal in any investment is to see returns on the money you put in. After all, there would be far fewer investors if they weren’t seeing benefits from their money. Therefore, it’s key that you understand just how much you could potentially gain from a given investment.
If you are already a real estate investor or are looking to start real estate investing but want to know how your investment will perform, it’s crucial to understand how much of a return on your investment (ROI) you can expect and exactly how that return is calculated.
In the world of real estate, calculating ROI is not always simple. Buying and selling homes can take time to complete and there are many related closing costs as well. In addition, your home’s price appreciation, as well as cash flow, can add to your return on investment while things like maintenance costs and repairs can subtract from them. Over the course of many years of owning a piece of real estate, there are different things to consider when calculating your return on investment. In this article, we will go over some of the ways you can calculate return on investment for your real estate assets.
What is ROI?
Return on investment is a measure of how well your investment performs, represented as a percentage of the amount returned based on your initial investment – essentially, how much your money has grown. ROI can be used by investors to measure the performance of any investment from real estate and REITs to stocks and more.
For example, if you bought a stock for $100 today and sold it for $110 dollars tomorrow (without paying any fees on the transaction), your return on investment would be 10%. This means on top of making back the principal, you made an additional 10% of income. Unfortunately, this particularly unrealistic example is far more simple than how things actually end up working, especially in real estate.
ROI is a very powerful tool for assessing your investment assets and for predicting performance before you invest. It can even help you compare two investments against each other in terms of their overall returns. It’s also a helpful measurement in areas like rentals, where your short-term returns can be used to determine profitability and
How to calculate real estate return on investment
There are a few different ways to calculate your return on investment depending on the asset in question.
You should also note that the following calculations work best when you assume constant values for most variables involved. Ultimately, however, this is not the case as , property tax, and mortgage rates can change a lot with time. It will be more complicated to calculate an exact return on investment in these cases.
To help with this, firstly, you should keep extensive records of all expenses and incomes related to your property so you can be sure the information is available if you need it. Beyond that, you can use tools like calculation software or even consult your investment advisor to determine an exact return on investment figure.
Calculating the return on investment of a home can be easy or complicated depending on your circumstances. To start, you need to know how much the home cost, but this doesn’t simply mean the purchase price of the home.
For one, you likely took out a mortgage and assuming you paid it all off before selling, there will be an amount above the purchase price that you paid in interest as well as closing costs. Then, there are also the regular costs you would have paid for the ownership of the home such as maintenance, property tax, utilities, and more. Finally, there will be the closing costs on the sale of the home as well.
A simple equation would be:
Total cost = purchase price + interest paid + closing costs + carrying costs
Profit from sale = sale price – closing costs
Return on investment = (profit from sale / total cost) X 100
For example, if your home cost you $850,000 since the time you owned it, including the purchase and all other expenses, and you sold it for $1,200,000 after closing costs, your profit would be $350,000, or around 41% return on investment.
It’s important that you consider the additional costs involved with a home as these can affect your bottom line when it comes to selling. Another example: say you paid $4,000 a year in property taxes on a home you owned for 10 years. That means you paid $40,000 in property tax over the course of your ownership. Even if you sell that home for $40,000 more than you bought it for, you have technically made no return on your investment. Luckily, homes tend to appreciate to an extent that you won’t completely erase your returns, however, you should still be aware of this factor.
This calculation can also be more complicated if you are selling a home that is still under a mortgage. Depending on the amount remaining on your mortgage and how much your home has grown in equity, you can be paying a significant amount back to your lender to close out your mortgage as well as any related fees for early repayment. If you still have a large amount of mortgage owed, this will affect your return on investment greatly.
Overall, you need to consider all costs involved and remember that return on income is based on your net profit only, not simply your gross sale price.
When it comes to calculating the return on investment of a rental property, it can be a bit more complicated than a simple home sale. In addition to any regular maintenance and carrying costs, rental properties are naturally creating income for the owner. This rental income will need to be taken into account.
Net operating income and cash flow
By looking at your monthly operating expenses and subtracting them from your rental income, you can determine your property’s net operating income. By taking your mortgage payments into account on top of your net operating income, you can determine the property’s overall cash flow per month. If you are spending less than you take in, your property is said to have positive cash flow. You can also use estimated values based on homes in the area to determine a rough monthly cash flow
Using a similar equation from before and subtracting rental income from your total costs, you can determine the return on investment of your rental property at the time of sale. If you have a positive cash flow, you can also look at the return on investment without selling through measures like your capitalization rate, but more on this later.
This is helpful because a lot of investors do not own rental properties for their appreciation value, but rather for the cash flow they can continuously earn. In many cases, it will be a better investment to continue to collect regular rental income than to sell the asset for a profit.
If you hold passive investments in real estate through options like a REIT or a real estate fund, you may find it quite easy to calculate the return on your investment. Generally, shareholders in organizations such as these, and in some cases, the general public, are able to easily access regularly compiled reports on the group’s holdings, their income, and their growth. Either directly or, with a bit of simple math, you can determine the return on your own investment.
Just remember to take into account any fees or taxes paid from your investment income.
What is a good ROI?
The question of how much return you hope to get on your investment will depend a lot on your individual circumstance. Everything from the property in question, financing terms, market conditions, and more, can affect your returns. However, it’s good to keep a realistic goal in mind as this will help you to know when your investments are not performing as well as you need. If you find your ROI is lower than you would like, it may be time to reexamine your investment and consider options such as reducing expenses, refinancing a mortgage, or selling the asset entirely.
There are a few general guidelines when it comes to investment ROI. Naturally, you should aim to see your investments grow faster than the rate of inflation as growth below this point is not really gaining you any money in terms of spending power. You should also consider your mortgage terms if you are financing an investment property. You will obviously be paying interest on your loan, so any investment should hopefully return more than you are spending on interest either in the long or short term.
You should also consider how your investment will perform across the time period you plan on owning it. For example, home prices can fluctuate and your ROI on a down year can vary drastically from your potential ROI on a good year. This can be an important thing to consider when you are looking to sell as sometimes waiting can earn you much more money.
Finally, you should consider the potential ROI you could be getting on other investments. If you own a rental property with a low ROI but have found other investment options with better returns, it doesn’t make sense to maintain that asset when that money could be doing more for you elsewhere.
In general, real estate tends to be a pretty steady investment whereas something like a REIT may look like it is getting good returns now, but can shift very rapidly due to market conditions.
Other measurements of profitability
Beyond directly measuring your return on investment, there are a few other metrics you can use to determine your investment performance.
The first is your capitalization rate, or, cap rate for short. The cap rate of a property is found by dividing the annual net operating income by the current market property value, converted to a percentage. This figure can give you an idea about how long it will take for the investment to break even as well as help you compare different properties without taking complicated mortgage terms into account.
Similar is the measure of cash-on-cash return. This metric measures the amount of money back for the actual value invested. So, rather than the current market value, you would compare your net operating income against how much you put in – your down payment, for example. Among other things, this can help you determine how much of a down payment you can offer while remaining profitable for a given property.
Internal rate of return
Finally, there is the internal rate of return (IRR). Your IRR is used to predict your investment’s future value based on projected growth and can tell you how profitable your investment will be, as well as how much risk is involved. Since the equation for calculating IRR is a bit more complex, you will probably want to use a calculator tool when looking at a property’s IRR.