A:

Return on Investment (ROI) is a performance metric used to evaluate the financial efficiency of an investment, or to compare the relative efficiency of multiple investments. It measures an investment’s gain or loss relative to the initial investment. ROI is calculated as follows:

ROI = (earnings – cost of investment) / cost of investment * 100%

ROI typically appears as a percentage; for example, investment XYZ has a ROI of 10%. The ROI calculation is the same for every type of investment – whether it’s stocks, real estate, or collectibles. The calculation can be manipulated, however, in terms of how costs and returns are accounted for. For example, real estate investors can use either the cost method or the out-of-pocket method to determine ROI.

Assume a real estate investor buys a house for $150,000, puts $50,000 into it for repairs and renovations, and then sells the property for $250,000. The investor’s equity position in the property is $250,000 – ($150,000 + $50,000) = $50,000. If the investor uses the cost method, the ROI will be calculated by dividing the equity by all costs:

$50,000 / $200,000 *100% = 25% ROI

If the investor instead uses the out-of-pocket method, the ROI will be calculated taking into consideration the down payment amount instead of the purchase price. A 20% down payment on the $150,000 property would be equal to $30,000, and total costs would be limited to this down payment plus the $50,000 for repairs and renovations, or $80,000 total. With the value of the property at $250,000, the investor’s equity position in the property would be $250,000 – ($30,000 + $50,000) = $170,000. The ROI again is calculated by dividing the equity by all costs:

$170,000 / $80,000 *100% = 212% ROI

As the example shows, the ROI for similar investments can vary greatly, depending on how the value is calculated. In these examples, the out-of-pocket method allows the investor to use leverage (by financing the property) to increase the ROI. It would be important, however, to take into consideration the costs associated with the loan, as they will affect the bottom line. It’s also important to stick to one method if more than one investment is being evaluated; otherwise, the results will be misleading.

RELATED FAQS
  1. What is the formula for calculating return on investment (ROI) in Excel?

    Find out more about return on investment (ROI) and the formula used for calculating return on investment for a company in ... Read Answer >>
  2. How do you use DCF for real estate valuation?

    Learn how discounted cash flow analysis is used for real estate valuation and the various factors that go into calculating ... Read Answer >>
  3. How can I make equity investments in real estate?

    Invest in real estate equity through buying and selling real property or through other more liquid investments like real ... Read Answer >>
Related Articles
  1. Investing

    How to Calculate ROI for Real Estate Investments

    Calculating return on real estate investments can be difficult. We help you figure it out.
  2. Investing

    How to Calculate the ROI of Rental Property

    The return on a real estate investment can vary greatly, depending on how much of the building you own.
  3. Financial Advisor

    How To Calculate Return On Investment (ROI)

    Return on investment allows an investor to evaluate the performance of an investment and compare it to others in his or her portfolio. Find out how to calculate ROI and how to use to your advantage. ...
  4. Insights

    Movie Genres That Make The Most Money

    Success in Hollywood isn't just measured by ticket sales - development costs play a large part, too.
  5. Tech

    How to Calculate ROI in Excel

    Daniel Jassy, CFA, shows how to calculate ROI in Excel.
  6. Investing

    Return on Investment (ROI) Vs. Internal Rate of Return (IRR)

    Read about the similarities and differences between an investment's internal rate of return (IRR) and its return on investment (ROI).
  7. Investing

    3 Ways To Evaluate the Performance of Alternatives

    Learn about three ways to measure the performance of alternative investments. See how the commonly used Sharpe ratio has drawbacks in measuring volatility.
  8. Investing

    5 Stock Market Metrics Explained

    Learn how to evaluate a company's performance using metrics such as ROE, EPS and P/E ratio.
  9. Taxes

    Where You Get the Most/Least for Your State Taxes

    Are you deriving the greatest benefits from your tax dollars? A recent survey from WalletHub may indicate otherwise.
  10. Managing Wealth

    6 Major Collectibles Payoffs

    From comics to records these rare items scored unbeatable returns for those who were able to recognize their value.
RELATED TERMS
  1. Return

    The gain or loss of a security in a particular period. The return ...
  2. Cash-On-Cash Return

    A rate of return often used in real estate transactions. The ...
  3. Average Cost Basis Method

    The average cost basis method is a system of calculating the ...
  4. Investment Property

    An investment property is a real estate property purchased with ...
  5. Average Cost Method

    The average cost method is an inventory costing method in which ...
  6. Shadow Inventory

    A term that refers to real estate properties that are either ...
Hot Definitions
  1. Earnings Per Share - EPS

    Earnings per share (EPS) is the portion of a company's profit allocated to each outstanding share of common stock.
  2. Trustee

    A person or firm that holds or administers property or assets for the benefit of a third party. A trustee may be appointed ...
  3. Gross Domestic Product - GDP

    GDP is the monetary value of all the finished goods and services produced within a country's borders in a specific time period, ...
  4. Debt/Equity Ratio

    The D/E ratio indicates how much debt a company is using to finance its assets relative to the value of shareholders’ equity.
  5. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange.
  6. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
Trading Center