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You’re thinking of getting into the real estate game, and you’re looking at a home with an asking price of $140,000 and you’ll need about $10,000 to make repairs and cover other expenses for a total of $150,000. It’s in a good neighborhood, and it doesn’t need much work to get it ready to rent. You’re itching to pull the trigger.
But will you actually make money? How do you know if the property is a good investment?
If you’re starting out on your real estate journey, one of the most important things to learn is how to calculate your return on investment (ROI). By learning how to calculate how much an investment property can potentially make for you, you’re far more likely to make a good investment now and even better ones in the future.
Calculating ROI in Real Estate Investing
Real estate investors buy properties with different goals and intents.
Some investors purchase properties with the intent of renting them out and the goal of creating a regular income stream through rental income. Others buy properties with the intent of buying early in a promising neighborhood and/or investing in repairs and remodels, with the goal of selling for a profit later.
Others may want to buy into a real estate investment trust (REIT) that lets them put in the money without needing to do the work of managing the property.
Regardless of intent and goals, every real estate investor should calculate ROI before buying. Here’s the simple formula for ROI.
- To calculate ROI, you subtract your investment costs from the total gains of your investment and divide the result by the cost.
- ROI = (investment gain – investment cost) / investment cost
Let’s say you purchase and improve the home you were looking at for $150,000, and you anticipate being able to sell it for $180,000.
Following the formula, ($180,000 – $150,000 = $30,000) / $150,000 comes out to 0.2 or 20%. A 20% return shows it’s a pretty solid investment.
Why is ROI important for real estate investors?
If you want to be a good investor, you need to understand ROI. Why? It will help you estimate your total costs and expenses and forecast the income you’ll earn.
Familiarity with ROI calculations also helps you compare properties, which is important for choosing between good and not-so-good investments. If you can estimate how much multiple properties will likely earn for you, you can narrow down your choices based on earning potential.
It’s also important to understand ROI so you can project future gains and expenses. If there comes a time when your projections show your expenses exceeding your ROI, you’ll need to decide to either ride it out and hope things improve, or sell your investment.
What is a good ROI for real estate?
Defining a good ROI depends on the situation, the property, your investment goals and how much risk you’re willing to take. That said, a lot of investors use the average returns in the stock market as a ruler. The S&P 500, for example, has had a net total return of around 14% over the past 10 years with some years posting higher returns and others posting negative returns.
There’s no hard and fast rule for ROI, but most experts agree that your real estate investments should provide an ROI of at least 5% and you should aim for an ROI between 8% – 12%.
But the definition of a good ROI also depends on variables such as the type of property and the location it’s in. For example, a home in one area may cost less upfront compared to one in another area. But the property in the second area may have a more robust real estate market with greater demand and higher prices. So while the second property may require a larger initial investment, it may also appreciate faster, increasing the potential for a larger ROI.
How To Calculate ROI on Rental Property
Usually, when dealing with rental investment properties, your focus is on cash flow or net income, which is the annual rental income minus expenses.
Let’s say your $150,000 property rents for $1,500 per month, producing $18,000 in annual rental income.
If you divide that $18,000 by the original $150,000 purchase, your ROI is 12%.
But you’ll need to factor in the extra expenses that come with maintaining a rental property. At a minimum, that includes property taxes and insurance. If you’re playing it smart, you’ll also want to include management costs and a reserve fund for repairs.
Once you’ve factored in these variables, you can subtract them from your gross rental income to get your cash flow. Let’s assume your annual return is $10,000 after expenses.
To calculate the ROI, divide your annual return by the total investment cost.
Your ROI is now 6.6%. Only slightly more than half of your return before expenses.
Generally, a good ROI for a rental property is above 10%, but between 5% and 10% is still acceptable. Keep in mind, there are no one-size-fits-all answers in real estate investing. Analyzing potential returns is important so you can know how much risk you’re willing to take.
How To Calculate ROI on Financed Transactions
Many investors, especially when they’re early in their real estate investment journey, use loans to purchase properties. If you aren’t closing with cash, you need to know how to calculate the costs of the loans into your ROI.
While initial costs with a loan are lower than with a cash purchase, there are more variables. You’ll need to account for the down payment (usually 20% of the purchase price) and closing costs, which can average around $5,000 – $6,000. Using the previous $140,000 purchase price as an example, that might amount to around $33,000. With the additional $10,000 in repairs, your initial cost adds up to $43,000.
- A mortgage means you must factor ongoing expenses into your ROI. After paying 20% down on a $140,000 home, you’ll have a $112,000 mortgage. On a fixed 30-year loan with a rate of 4.5%, your monthly payment would be $567.49.
- If you subtract that from the gross rental income of $1,500 per month, you get a net rental income of $932.51 per month or $11,190.12 per year.
- From there, you’d follow the usual formula to determine your ROI, which provides an ROI of about 7.4%.
How To Calculate ROI on Cash Transactions
If you’re a cash buyer, things are a little simpler. To clarify, a cash buyer is someone who’s using their own funds to cover the purchase price rather than a loan. Some people buy homes with savings or with the sale of another property. Seasoned investors may also pay cash to purchase a property for resale.
- To find the ROI on cash transactions, you calculate the annual return on the property – which is the income from the property minus any expenses – and then divide that by the amount you paid:
- ROI = (income – expenses) / cash price
Following the earlier example, if you purchased the $140,000 home outright and spent another $10,000 to improve it, your total cost is $150,000. Let’s say you then rent for $1,500 per month for a year, amounting to $18,000 in rental income. You pay $5,000 in that same year for upkeep and management.
Your ROI is now 8.7% or 1.4% higher than it would be with the mortgage.
How To Calculate Returns From REITs
A real estate investment trust, or REIT, is a business that owns or finances investment properties to generate income. Calculating ROI for REITs is a little more complicated, as they’re required by law to distribute 90% of profits as dividends to shareholders.
Returns from REITs are called yields, and they’re the amount of money paid to shareholders at regular intervals. They’re expressed as annual percentages of the investment’s price.
- To calculate a REIT yield, add up the expected distributions for a 12-month period.
- Divide this number by the current price of the REIT and you have your yield expressed as a percentage.
Limitations of the ROI Calculation
Like most investment calculations, the formulas for ROI are useful, but they don’t account for every possible variable. These are three key variables to consider when running the numbers to determine ROI.
Adjustable-rate mortgages (ARM)
An ARM, for example, can complicate simple ROI calculations. An ARM can offer lower interest rates when compared to a fixed-rate mortgage. But with an ARM, your interest rate is fixed only for a certain amount of time, usually an introductory period ranging from 3 – 10 years.
After that, it resets periodically with intervals ranging from 6 months to 5 years. This makes predicting ROI problematic once your introductory period ends. For this reason, you may want to revise your ROI annually if you use an ARM for your investment property. ARMs are a great choice if interest rates are high or you plan to sell your investment property before the introductory period ends.
Another factor that’s difficult to predict for rental property investors is tenant instability. Even the best investors and property managers can’t always guarantee 100% occupancy. And even then, if you rent to a tenant that leaves your property in disrepair, you’ll have to pay to fix what they broke.
Or if your tenant loses their job or can’t pay their rent for other reasons, you may have to go without the rental income while you either make other arrangements with the tenant or begin eviction proceedings. After that, your income will still be on hold until you can find a new tenant.
Maintenance and ownership costs
And of course, the costs of owning and maintaining properties are impossible to forecast. You might only need small repairs here and there, but there’s always the possibility of some kind of epic failure that requires serious money to make repairs.
Having liability insurance can help, but your insurance won’t always cover every expense, and you may still lose income while making repairs.
With enough experience, investors can better predict these kinds of things, but it’s still difficult. One way to help mitigate these unknowns is by using real estate investment software or specialized calculators.
These tools use advanced calculations and compare large quantities of data to predict performance, so they’re definitely worth looking into.
Other Metrics for Calculating Real Estate Profitability
Calculating ROI is undeniably useful, but it’s only one of many methods you should use to determine real estate profitability.
Internal rate of return
The internal rate of return, or IRR, is a calculation that measures ROI over a specific length of time. It takes cash flow and any other profits into account, such as from the sale of the property. In short, IRR calculates the net cash flow and property appreciation divided by the length of time you hold the property.
Cash-on-cash return is another metric that measures the ratio of annual cash flow relative to the amount you invested in the beginning. It’s a reliable indicator of how an investment property will perform.
Lastly, the capitalization rate – usually called the cap rate – is another calculation used to estimate the ROI of an investment property. It’s similar to the cash-on-cash calculation but only considers the initial purchase price. It also doesn’t factor in loan expenses.
Keep in mind that it’s wise to use multiple ROI methods when researching a potential investment. Taking the time to learn about the different calculations helps you look at properties from different angles. You might spot something – good or bad – you would have otherwise missed by using a single calculation.
Making Sure Your Investment Is Worth It
Understanding how to calculate ROI is key to a successful real estate investment. But remember, there is more than one method for understanding the potential payoff on a property, so be sure you do your homework and stay consistent with your calculations.