The goal of real estate investing is realizing a sizable profit. Understanding the return on investment (ROI) concept and how to calculate it is critical to meeting that goal.
Several methods of calculation can show the return on an investment. The bottom line is how much money you end up with after deducting various costs. ROI tends to be higher when costs are lower.
Calculating ROI can be a helpful tool in gauging the value of an investment. You're not buying property to lose money, and you'll want a rough idea of how much you stand to gain if you decide to move ahead with the purchase.
In purest terms, ROI can be expressed as your gain from an investment less the cost of your investment, divided by the cost of your investment.
The Cost Method: An Example
You've bought a property for $200,000 and you subsequently spent $100,000 on maintenance. It's valued at $400,000 at the time of sale.
Your total investment is $300,000: the $200,000 purchase price plus your maintenance costs. This results in equity of $100,000: the $400,000 value less your investment.
Dividing $100,000 by $300,000 produces an ROI of 33%. This assumes that you've included all maintenance costs of your period of ownership.
The Out-of-Pocket Method
This is the preferred method used by real estate investors because it can often produce higher ROIs.
An investor might purchase a $120,000 property with a $100,000 loan and a $20,000 cash down payment. The investor then spends $50,000 on maintenance. The total out-of-pocket expenses are therefore $70,000: the $20,000 down payment plus the $50,000 spent on maintenance.
The investor would be left with $130,000 if the property was valued at $200,000—a $200,000 sales price less the $70,000 in out-of-pocket expenses. Divide $130,000 by the $200,000 value to arrive at an ROI of 65%.
The loan amplifies the return, which is almost double that in the cost method example.
These Are Very Basic Calculations
It's almost inevitable that you'll have other costs of ownership in addition to maintenance, such as costs of sale and management fees during your time of ownership. These should be added in for a more accurate ROI. Ideally, you should also consider mortgage interest in the out-of-pocket method scenario.
Some methods subtract your expenses from your rental income, then add equity to arrive at net income. Equity is the current market value of your property less your loan or mortgage amount.
You would then divide that number by your total investment to arrive at your ROI, but this equation assumes that you're renting out the property. It's not an end-of-the-deal purchase/sale investment.
Purchase/sale methods assume that the property sells for full value, which is not always the case. It doesn't take market conditions or other economic factors into consideration.
Get advice and guidance from a professional if you're calculating for tax purposes.
Calculating Net Proceeds
You might also prefer to use net proceeds as an indicator of overall financial performance. This is more complicated because it includes more detailed factors and it covers a specified period of time.
Assume that you've purchased a property for $200,000. If you plan to sell in 10 years and your property is appreciating at an average of 3% a year, it would be worth $260,000 in year 10. You've paid your mortgage down to $125,000 at your target sale date.
Assuming your costs of sale are $10,000, your net proceeds after 10 years would be $125,000: $260,000 less the mortgage of $125,000 less $10,000 in sales costs. That works out to about $12,500 a year, which might be acceptable for passive ownership, but it's less than idea if you're a hands-on investor.