Return on investment (ROI) is a measurement of how much money or profit is made on an investment as a percentage of its cost. Since this metric shows how well your investment dollars are being used, it pays to know both what ROI is and how to calculate ROI in real estate.
- Return on investment (ROI) measures how much money or profit is made on an investment as a percentage of the investment's cost.
- Return on investment (ROI) shows how effectively and efficiently investment dollars are used to generate profits.
- Many investors use the average returns on the S&P 500 as the benchmark for a target return on investment (ROI).
Return on investment (ROI) is an accounting term that indicates the percentage of invested money that's recouped after deducting associated costs. For the non-accountant, this may sound confusing, but the formula may be simply stated as follows:
ROI=CostGain−Costwhere:Gain=Investment gainCost=Investment cost
This equation seems easy enough to calculate. However, a number of variables come into play, including repair and maintenance costs, as well as leverage—the amount of money borrowed (with interest) to make the initial investment. These variables can affect ROI numbers.
How to Calculate ROI For Real Estate Investments
Complications in Calculating ROI
When you buy property, the financing terms can greatly impact the overall cost of the investment. Complications in calculating ROI can occur when a property is refinanced or a second mortgage is taken out. Interest on a second loan, or a refinanced loan, may increase, and loan fees may be charged—both of which can reduce the ROI.
There may also be an increase in maintenance costs, property taxes, and utility rates. If the owner of a residential rental or commercial property pays these expenses, all these new numbers need to be plugged in to update the ROI.
Complex calculations may also be required for property bought with an adjustable-rate mortgage (ARM)—a loan with a rate that changes periodically through the duration of the loan.
Let's look at the two primary methods to calculate ROI: the cost method and the out-of-pocket method.
The Cost Method
The cost method calculates ROI by dividing the equity in a property by that property's costs.
As an example, assume a property was bought for $100,000. After repairs and rehab, which costs investors an additional $50,000, the property is then valued at $200,000. This makes the investors' equity position in the property $50,000 (200,000 – [100,000 + 50,000] = 50,000).
To use the cost method, divide the equity position by all the costs related to the purchase, repairs, and rehabilitation of the property.
ROI, in this instance, is $50,000 ÷ $150,000 = 0.33, or 33%.
The Out-of-Pocket Method
The out-of-pocket method is preferred by real estate investors because of higher ROI results. Using the numbers from the example above, assume the same property was bought for the same price, but this time, the purchase was financed with a loan and a down payment of $20,000.
The out-of-pocket expense is thus only $20,000—plus $50,000 for repairs and rehab—for a total out-of-pocket expense of $70,000. With the value of the property at $200,000, the equity position is $130,000.
The ROI in this case is $130,000 ÷ $200,000 = 0.65, or 65%. This is almost double the first example's ROI. The difference, of course, is attributable to the loan: leverage as a means of increasing ROI.
What Is a Good Return on Investment (ROI) for Real Estate Investors?
What one investor considers a "good" ROI may be unacceptable to another. A good ROI on real estate varies by risk tolerance—the more risk you're willing to take, the higher ROI you'll expect. Conversely, risk-averse investors may happily settle for lower ROIs in exchange for more certainty.
In general, however, to make real estate investing worthwhile, many investors aim for returns that match or exceed the average returns on the S&P 500. The historical average S&P 500 return is 10%.
Of course, you don't have to buy physical property to invest in real estate. Real estate investment trusts (REITs) trade like stocks on an exchange, and they can provide diversification without the need to own and manage any property. In general, REIT returns are more volatile than physical property (they trade on an exchange, after all). In the U.S., the annual return of REITs is 12.99%, as measured by the MSCI U.S. REIT Index.
Return on Investment (ROI) Doesn't Equal Profit
Of course, before ROI can be realized in actual cash profits, the property must be sold. Often, a property will not sell at its market value. A real estate deal may close below the initial asking price, which reduces the final ROI calculation for that property.
Also, there are costs associated with selling a real estate property, such as funds expended for repairs, painting, and landscaping. The costs of advertising the property should also be added in, along with appraisal costs and the commission to the real estate agent or broker.
Mortgage lending discrimination is illegal. If you think you've been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development (HUD).
Both advertising and commission expenses may be negotiated with the service provider. Real estate developers with more than one property to advertise and sell are in a better position to negotiate favorable rates with media outlets and brokers. ROI on multiple sales, however, with varying costs for advertising, commission, financing, and construction presents complex accounting issues that are best handled by a professional.
The Bottom Line
Calculating ROI on real estate can be simple or complex, depending on all the variables mentioned above. In a robust economy, investing in real estate—both residential and commercial—has proven to be very profitable. Even in a recessionary economy, when prices fall and cash is scarce, many bargains in real estate are available for investors with the money to invest. When the economy recovers, as it inevitably does, many investors can reap a handsome profit.