Calculating ROI on a Real Estate Investment
The purpose of a real estate investment is, of course, to make money. Real estate is one of the most popular types of investments. There are different types of real estate investments, but the most common one is purchasing a physical property. This doesn’t just mean houses — physical properties include a plot of land used for any of a variety of purposes, the most common being residential, commercial, and industrial. Real estate can also be used for agricultural use, mixed-use, and special use. Typically, someone invests in real estate either to make a rental income or to quickly increase the value of the property and resell it.
With any real estate investment, it’s essential to calculate ROI, or return on investment, before making any financial decisions. ROI is a measure of a property’s potential profitability, or how much profit you stand to make as a percentage of the investment cost. While it’s also important to look at the total profit you stand to make, ROI is an indication of how efficiently investment dollars are being used.
The process for calculating ROI is different depending on the type of investment, and there are many variables that influence ROI for property investments. One of the most important parts of calculating real estate ROI is determining which variables should be included or excluded. It’s usually a good idea to do multiple calculations for the same property — just be sure you are including all the same variables or the most relevant variables if you are comparing multiple properties.
The ROI Formula
The basic calculation for ROI on real estate property is first taking the annual gain on the investment, or how much money you will make, and subtract the annual cost of the investment. Then, divide this number by the original cost of the investment. The result is a percentage representing the investment profitability.
While this basic formula is always the same, there are variety of variables that will impact the calculation on investment cost and gain, especially when it comes to real estate. Some of these variables include maintenance expenses, closing costs, vacancies, and unexpected repairs. Another key factor is cash transactions versus financed transactions.
Cash Transactions and ROI
Calculating ROI is more straightforward for cash transactions, or buying a property in full. Let’s look at an example:
Original cost: You pay $90,000 in full for a rental property. After closing costs and remodeling costs of $15,000, your total investment cost is $105,000.
Annual return: You sign a 1-year lease with a tenant and rent the property for $950 a month, totaling $11,400 in revenue after one year. Property expenses such as utilities, maintenance, insurance, and taxes total $100 a month, or $1,200 after one year. Your annual return or annual gain ($11,400 – $1,200) is $10,200.
Return on investment: Dividing the annual gain by the original investment cost, the ROI is $10,200 ÷ $105,000 = .097 or 9.7%. This means that each year, you make 9.7% of your original investment back.
Financed Transactions and ROI
With financed transactions, or properties purchased with a mortgage, calculating ROI is a bit more complicated. Let’s look at an example with the same property:
Original cost: The property price is the same ($90,000), but you take out a mortgage with a downpayment of 20%. The downpayment on the mortgage totals $18,000, and closing and remodeling costs total $15,000. Your original investment cost is $18,000 + $15,000 = $33,000.
Annual return: Your mortgage was a 30-year loan with a fixed interest rate of 4%. The monthly principal and interest payment on the borrowed $72,000 is $343.74. This totals $4,124.88 after one year. Property expenses remain the same at $1,200 annually. Therefore, total expenses after one year total $5,324.88. You collect the same amount in revenue, $11,400 after one year. Your annual return or annual gain on the property is $11,400 – $5,324.88 = $6,075.12.
Return on investment: Dividing the annual gain by the original investment cost, the ROI is $6,075.12 ÷ $33,000 = .184 or 18.4%. This means that each year, you make 18.4% of your original investment back.
For the purpose of understanding ROI, these examples were over-simplified and included minimal variables. It’s essential to consider as many variables as possible that should be included in a calculation, and to have conservative estimates for unexpected events. Here are some of the most often forgotten factors to include:
- Unexpected repairs: Appliances and systems like the air conditioning may need to be replaced, or events like natural disasters can occur that will require upwards of thousand of dollars.
- Vacancies: Your property will not stay rented 100% of the time, and may take longer than expected to rent. You still have to pay property expenses during vacant months.
- Marketing costs: Again, it might take longer than expected to rent a property, and marketing costs add up.
- Changes in the market and the surrounding area: It’s important to consider how the real estate market as a whole will change over time, and the prospects of the area surrounding the property.
- Property management: Being a landlord is a full time job, and often times hiring a property manager is a cost-effective way to offer high quality management services and grow your opportunities as an investor.
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