How to find your real estate investment return (ROI)

Return on investment (ROI) is a measure of the percentage of capital or profit received from an investment as a percentage of its cost. Since this indicator shows the use of your investment funds, it is worthwhile to understand what the return on investment is and how to calculate the return on real estate investment.

Key points

  • Return on investment (ROI) measures the percentage of capital or profit obtained from an investment in the cost of an investment.
  • Return on investment (ROI) shows how to use investment dollars effectively and efficiently to generate profits.
  • Many investors use the average return of the S&P 500 index as a benchmark for target return on investment (ROI).

Return on investment (ROI) is an accounting term that represents the percentage of investment funds that are recovered after deduction of related costs. For non-accountants, this may sound confusing, but the formula can be simply stated as follows:

ROI = Gain − Cost Cost where: Gain = investment income Cost = investment cost begin{aligned} &text{ROI} = frac {text{Gain}-text{Cost} }{text{Cost}} \ &textbf{where:}\ &text{Gain} = text{Investment income}\ &text{Cost} = text{Investment cost}\ end{aligned}

Return on investment=costgetcostWhere:get=Investment incomecost=cost of investment

This equation seems to be easy to calculate.However, many variables come into play, including repair and maintenance costs, and leverageThe amount borrowed for the initial investment (with interest). These variables will affect the return on investment figures.

How to calculate the return on investment of real estate investment

The complexity of calculating the return on investment

When you buy a property, the financing terms will greatly affect the overall cost of the investment. When the property is refinanced or the second mortgage is taken out, the calculation of the return on investment may be complicated. The interest on the second loan or refinancing loan may increase, and loan fees may be charged-both of which will reduce the rate of return on investment.

Maintenance costs, property taxes and utility fees may also increase. If the owner of a residential lease or commercial property pays these fees, all these new figures need to be inserted to update the return on investment.

Complex calculations may also be required for real estate purchases using an adjustable rate mortgage (ARM), which is a type of loan where the interest rate changes periodically over the loan term.

Let’s look at the two main methods of calculating ROI: cost method and out-of-pocket usage.

Cost method

The cost method calculates the rate of return on investment by dividing the net asset value by the cost of the asset.

For example, suppose you buy a real estate for $100,000. After repairs and restoration, investors need to pay an additional US$50,000, and the value of the property is US$200,000. This makes the investor’s equity position in the property 50,000 USD (200,000- [100,000 + 50,000] = 50,000).

To use the cost method, divide the equity position by all costs associated with purchasing, repairing, and restoring the property.

In this case, the return on investment is 50,000 USD ÷ 150,000 USD = 0.33, or 33%.

Self-financed method

Due to the high rate of return on investment, the out-of-pocket method is the first choice for real estate investors. Using the numbers in the example above, suppose that the same property was purchased at the same price, but the funds for this purchase were a loan and a $20,000 down payment.

Therefore, the out-of-pocket expenses are only USD 20,000 (plus USD 50,000 for repairs and rehabilitation), and the total out-of-pocket expenses are USD 70,000. The value of the property is US$200,000 and the equity position is US$130,000.

In this case, the return on investment is 130,000 USD ÷ 200,000 USD = 0.65, or 65%. This is almost twice the return on investment of the first example. Of course, the difference can be attributed to loans: leverage is a means of increasing the rate of return on investment.

What is a good return on investment (ROI) for real estate investors?

A return on investment that one investor considers “good” may not be accepted by another investor. The return on a good real estate investment varies with risk tolerance-the more risk you are willing to take, the higher the return on investment you can expect. Conversely, risk-averse investors may be willing to accept a lower return on investment in exchange for more certainty.

However, in general, in order to make real estate investment valuable, many investors aim to meet or exceed the average return of the Standard & Poor’s 500 Index. The historical average return of the S&P 500 Index is 10%.

Of course, you don’t have to buy physical assets to invest in real estate. Real estate investment trusts (REITs) trade like stocks on exchanges, they can provide diversification without having to own and manage any property. Generally speaking, REIT returns are more volatile than physical assets (after all, they are traded on exchanges). In the United States, as measured by the MSCI US REIT Index, the annual return rate of REITs is 12.99%.

Return on investment (ROI) is not equal to profit

Of course, the real estate must be sold before the return on investment can be realized in actual cash profits. Usually, real estate is not sold at its market value. The closing price of a real estate transaction may be lower than the initial asking price, which will reduce the calculation of the final return on investment of the property.

In addition, there are costs associated with the sale of real estate, such as funds for repairs, painting, and landscaping. It should also add the cost of real estate advertising, as well as evaluation fees and real estate agents or broker commissions.

Both advertising and commission fees can be negotiated with the service provider. Real estate developers who own more than one property to advertise and sell are better able to negotiate preferential prices with the media and brokers. However, because advertising, commissions, financing, and construction costs vary, the ROI of multiple sales raises complex accounting issues, which are best handled by professionals.

Bottom line

Calculating the rate of return on real estate investment can be simple or complex, depending on all the variables mentioned above. In a strong economy, investing in real estate—residential and commercial—has proven to be very profitable. Even in the economic downturn, when prices fall and cash is scarce, investors with capital to invest can get many cheap real estate. When the economy recovers, this is inevitable, and many investors can make considerable profits.

However, for income tax or capital gains tax purposes, we urge real estate owners to obtain professional tax advice from reliable sources before submitting applications.

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READ ALSO:   REIT tax basis
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