The real estate industry offers investors viable channels of profit making and wealth building. Like other sectors, people invest to earn enough money to live the life of their dreams, or keep enough for their retirement. One of the most common ways to make money from real estate is by buying investment properties. Investors may buy these properties to earn rental income from them or to sell them for profit after a short while.
It is important to be able to tell how much profit you will get for every investment you make. Knowing the profit potential of an investment property tells you whether it is good value for your time and resources, or whether you should look elsewhere. Simply put, potential returns from a property informs your investment decisions.
The return on investment (ROI) of a property is a financial metric, used to calculate the profitability of an investment. For investment property, ROI tells you whether to invest by providing based on certain parameters, the profit margin you would expect on an investment. Thus, it is necessary for investors to learn how to calculate ROI on investment property before buying any property. This article will show you how to calculate ROI on investment property and how to determine whether the ROI on investment property is good enough.
Calculating ROI on Investment Property
Calculating ROI on rental property or other types of investment property is fairly straightforward. You do not need any complex mathematical formula to understand how ROI works. It is also necessary to bear in mind that ROI is merely an estimate that reflects the level of detail that you put into your analysis. Knowing how to calculate ROI on investment property is one part of the process. How you calculate other variables like financing and maintenance costs on investment property can affect your ROI estimate.
So how do you calculate your return on investment? The basic formula for calculating ROI is pretty simple:
ROI = (Investment Income – Cost of Investment)/Cost of Investment
Where
Investment Income = How much you made from the investment over some time
Cost of Investment = The cost of setting up the investment
So if you spent $10,000 on an investment and received an income of $12,000 after a year, your ROI becomes:
($12,000 – $10,000)/$10,000 = 0.2
ROI is a measure of profitability, expressed as percentage returns. So the ROI for our example is 0.2 X 100 = 20%
The formula is relatively easy and straight to the point. However, it may not suffice if you want to calculate return on investment in real estate. It does not account for investment property variables like repair and maintenance expenses, financing, lack of income during vacancies, and interest on loans.
ROI on a Financed Property
For example, let’s calculate ROI on an investment property you financed with a mortgage.
Say the investment property cost $200,000, and you had to make a 20% ($40,000) down payment on the property. You also had to pay $5,000 as closing costs and $20,000 for renovations.
Total cost of investment: ($40,000 + $5,000 + 20,000) = $65,000.
Other costs associated with your investment:
- Say your mortgage is for 30 years at a 4% interest rate. On your $160,000 loan, you will have to pay $160,000 X 4% X 30 = $192,000 translating to a monthly principal and loan payment of $533.34
- If you have to pay an additional $200 to cover insurance, taxes, and utilities, you will be paying $733.34 monthly
- Rental income of $2,000 monthly means you are earning $24,000 every year
- Your monthly cash flow becomes $2,000 – $733.34 = $1266.66
Your annual returns: $1266.66 X 12 = $15,199.92
ROI in this investment property becomes
ROI = Annual Returns/Total cost of Investment
ROI = $15,199.92/$65,000 = 0.234 = 23.4%
ROI for Cash Transactions
If you paid for the property without a mortgage, the calculation becomes:
Cost of Investment = $200,000
Associated Costs = $5,000 closing costs + $20,000 for renovations totaling $25,000
Total Costs of Investment = $200,000 + $25,000 = $225,000
Monthly rental income of $2,000 means you get $24,000 a year
Additional $200 monthly to cover insurance, taxes, and utilities = $2,400 per year
Annual Returns: $24,000 – $2,400 = $21,600
ROI = Annual Returns/Total Costs of Investment
ROI = $21,600/$225,000 = 0.096 = 9.6%
Using a Return on Investment Calculator
Suppose you want to make profitability forecasts on an investment property without knowing how to calculate ROI on an investment property. In that case, you can get valuable estimates by using an online real estate investment calculator. With this calculator, you only need to enter the details of the investment in the spaces provided, and the ROI calculator furnishes you with a profitability estimate of the property.
The 1% Rule
Many real estate experts advance the 1% rule for evaluating the profit potential of an investment. The rule states that the monthly rent on an investment property should be greater than or equal to 1% of the property’s total cost. This rule does not account for expenses such as a mortgage, repairs, insurance, and taxes. The 1% rule is not ironclad and only serves as a rough guide for determining a property’s profit potential.
What is a portfolio loan?
If you are new to the real estate industry, I’m sure you have a question in your mind what is a portfolio loan? A portfolio loan is a kind of mortgage that a lender originates and retains instead of offloading on the secondary mortgage market. Because a portfolio loan is kept in the lender’s portfolio, or “on the books,” the lender sets the standards — and sometimes favorably for borrowers.
What Is a Good ROI on Investment Property?
You want to invest in real estate to make a profit. But how much ROI is good enough to make you buy an investment property. There is no straight answer to this question. What constitutes a good ROI depends on an investor’s risk tolerance and other factors like investment location, property type, and rental income.
For cash investments, an ROI of 4 to 10% is considered okay by most experts. A higher cap rate comes with more risk, so your risk tolerance largely determines your target ROI. If your investment is mortgaged-financed, a good ROI is anything above 8% for most experts. You can choose to increase the ROI you aim for after you have evaluated all the variables affecting your investment.
Summary
Real estate investing is a time-trusted way of earning money and diversifying one’s wealth portfolio. Like any other investment, it is crucial to perform due diligence to know what to expect and how to avoid costly mistakes. Calculating ROI on prospective investments helps you make informed and profitable investment decisions.