Return on Investment (ROI) is a measure of the return on money or investment, expressed as a percentage of the expenditure. Because this metric shows how well your investment dollars are being used, it pays to know what ROI is and how to calculate real estate ROI.
Complexity of ROI calculation
When you buy real estate, the terms of financing can have a big impact on the total cost of your investment. There may be complications in calculating ROI when refinancing an asset or taking a second mortgage. The interest on a second loan or refinanced loan may increase and loan fees may apply, which may reduce ROI.
Maintenance costs, property taxes and utilities may also increase. If these costs are borne by the rental or commercial property owner, all these new numbers need to be plugged in to improve ROI.
Interest rates can also require complex calculations for loans obtained with a controlled mortgage (ARM), the interest rate of which varies periodically over the life of the loan.
Let us look at two main methods of calculating ROI: cost method and redemption method.
Cost method:
Under the cost method, ROI is calculated by dividing the capital by the cost of assets.
For example, suppose an asset is purchased for 100,000. After repairs and rehabilitation, which cost investors an additional $ 50,000, the property is valued at $ 200,000. For this reason, the investors’ equity position is $ 50,000 (200,000 – [100,000 + 50,000] = 50,000).
To use the cost method, divide the property by the total cost of purchasing, repairing, and retrieving the property.
In this case, the ROI is $ 50,000 ÷ $ 150,000 = 0.33 or 33%
Pocket method
Real estate investors prefer the “out of pocket” approach because of the high ROI. Using the numbers from the example above, suppose the same property was purchased at the same price, but this time the purchase was financed with a loan and a ডাউন 20,000 down payment.
So it costs only $ 20,000 out of pocket, plus $ 50,000 for repairs and rehabilitation and the total cost is $ 70,000. When the value of the property is $ 200,000, the equity is $ 130,000
In this case ROI is $ 130,000 ÷ $ 200,000 = 0.65 or 65% This is almost double the ROI of the first instance. The difference, of course, relates to debt: leverage as a way to increase ROI.
What is a good return on investment (ROI) for real estate investors?
What an investor thinks is a “good” ROI may be unacceptable to others. A good return on real estate investment depends on risk tolerance: the more risk you are willing to take, the higher the ROI you will expect.
Conversely, risk-averse investors may be satisfied with a lower return on investment in exchange for greater security.
However, to be valued for investing in real estate, many investors often look for returns equal to or greater than the average return on the S&P 500. The S&P 500’s historical average return is 10%.
Return on investment (ROI) is not profitable
Of course, the asset must be sold before the cash ROI can be realized. Assets are often not sold at market prices. A real estate transaction can be made at a lower price than the initial sale price, which reduces the final ROI calculation for that real estate.
Additionally, there are costs associated with selling real estate, such as spending money on repairs, painting and landscaping. The real estate advertising fee, appraisal fee and commission to the real estate agent or broker must be added.
Both advertising and commission costs can be negotiated with the service provider. Property developers with multiple properties listed and for sale may be better able to negotiate with the media and brokers at favorable prices.
However, the ROI of multiple sales, including various advertising, commissions, financing and construction costs, is a complex accounting problem that is best solved by a professional.
Lastly
Calculating real estate ROI can be simple or complex, considering all of the above variables. With a strong economy, investing in real estate, both residential and commercial, has become very lucrative.
Even in a low economy where prices are falling and cash is tight, there are plenty of real estate deals for investors who have money to invest. When the economy is recovering, inevitably.