It’s easy to look at wealthy investors, and assume that they just got lucky. Maybe they were in the right place at the right time, or somehow made their millions by chance.
But wealth creation doesn’t happen by accident. Sure, some people inherit wealth, but even in those cases, that wealth needed someone to create it originally. Success comes to those who know what they’re doing, and are willing to work hard to make it happen.
So how do the world’s richest people make their money? In 2019, Forbes reported real estate came in third for how the world’s billionaires made their wealth. For others though, even if they didn’t use real estate as their primary source of income, they certainly diversified with it. Using it as a store of wealth, or for some of the valuable tax breaks that it offers.
Success with real estate depends primarily on two things: finding a profitable investment in an emerging market, and how well that property is managed. A smart investor treats real estate like any other business. They plan ahead, run the numbers, and ensure that the market they’re planning to enter is one that’s expected to experience growth, or at least, generate returns that are in line with their investing goals.
Taking the time to run the numbers can help to reduce risk when buying a property. Take it from Warren Buffett, who says, “Risk comes from not knowing what you’re doing.”
With this in mind, let’s take a look at calculating your projected returns on a potential property. A crucial step when it comes to assessing the viability of an investment.
Calculating ROI
ROI is a percentage that clarifies how much money or profit you can make on an investment. It takes into account all of the costs to acquire something, including loans. It’s simple to compute and can be used for a variety of applications involving investments.
ROI Applications for Real Estate
ROI is a great tool for helping you plan your investment strategy. Here are some of the ways that you can use it:
- Make smarter purchasing decisions. Knowing the ROI of a property right off the bat can help you decide whether to go for the investment or pass on it. If you’re looking at several properties, knowing the ROI helps you decide which one will be the most profitable venture, or will assist you in ranking them according to your goals.
- Goal-setting. Are you looking to have a stable source of passive income? Are you saving up for retirement? Having an idea of the ROI allows you to set investment goals and classify them according to your short-term or long-term plans.
See Also: How Property Investment Can Bring You Financial Freedom
- Ensure ongoing profitability. So, you finally decided to buy a property. It pays to still closely monitor your metrics even after your purchase. That way, you’ll know if your unit continues to be profitable.
Cash Flow
First up, let’s look at cash flow. It’s a great starting point when running the numbers and you’ll need this figure when making other calculations.
Cash flow is the total cash you have at the end of each month after paying all the operational expenses and saving money for future repairs. For rental properties, it’s an incredibly useful metric to have in your back pocket, especially if your investment goal is to make passive income.
Cash flow is a source of immediate income and should ideally increase over time, in line with inflation rates, while your mortgage payment remains the same.
Cash Flow formula: Gross rental income - all expenses, including vacancy and repair reserves
Of course, cash flow isn’t the only consideration. You’ll want to consider appreciation, as well as the overall health of the housing market that you’re thinking of investing in.
Just getting started with investing? Read: Getting Started With Rental Properties: Investing In Your Own Backyard
Calculating ROI on Your Rental
Next, let’s calculate the basic projected ROI of a potential investment. The formula sounds complex but works simply. You just subtract the cost of the investment from the gains and divide it by the entire cost of investment. Then multiply that figure by 100.
ROI formula = (Gain from Investment - Cost of Investment) / Cost of Investment x 100
For example, let’s say you purchase a house for $300,000. Five years later, you decide to sell it for $380,000. You simply divide the net profits ($380,000 - $300,000 = $80,000) by the investment cost ($300,000). That gives you an ROI of 27% (5.4% per year), which is a decent return on investment, especially since this calculation only includes appreciation, not cash flow.
ROI for Real Estate and Rental Properties
When it comes to real estate however, there are other variables that should be factored in when calculating value. Rental properties also tend to have extra monthly recurring costs.
These expenses include things like:
- Mortgage expenses (Interest and PMI)
- Taxes and fees
- Closing costs (lawyers, appraisals)
- Remodeling and repairs
- Vacancies (Factor in 10% per year)
- Maintenance and repairs
- Property management
- HOA fees
- Insurance
Though rental properties tend to have extra costs, the good news is that these costs should be offset by the monthly rental income that you collect from tenants. This also factors into the ROI computation. You’ll see how this looks in our sample, below.
Real Estate ROI for Cash Transactions
Properties bought with cash are pretty straightforward to calculate.
ROI Formula for Cash Transactions: Annual Return / Cost of Investment x 100
To illustrate this better, here’s an example of a property paid in full with cash:
You buy a property for $100,000.
You spend $8,000 on renovations.
You spend another $2,000 on closing costs.
Your total cost of investment will be $110,000.
Every month, you collect rent of $800, after expenses.
At the end of one year:
You earned $9,600 in rental income, after expenses.
Next, you take the annual return of $9,600 and divide it by the amount of total investment, $110,000.
$9,600 / $110, 000 = 0.087 x 100
If you pay all-cash, your ROI is 8.7%.
Out-of-Pocket ROI
Now, let’s calculate your out-of-pocket ROI if you were to use financing. Financing is one method that’s often preferred by real estate investors because it can yield a much higher ROI. Using the numbers from the example above, let’s assume the same property was bought for the same price, but that it was financed using a loan and a down payment of $20,000.
The out-of-pocket expense is then $20,000, plus $8,000 for repairs for a total cost and $2,500 for closing costs. Note that for mortgages, closing costs are typically higher.
Your total out-of-pocket expenses for this investment amounts to $30,500.
The ROI in this case would be $30,500 / $100,000 = 0.65 x 100, or 65%. So a lot higher! The difference, of course, is that you’re using a loan to obtain leverage and increase your ROI.
Considerations: How much you pay for the property at the start greatly influences the ROI.
Looking at these two examples, you can see that the more finance, the greater your ROI. This is because you’re able to use leverage, rather than your own money out-of-pocket, to finance the investment. You will save on interest if you pay all-cash, but you will also miss out on the chance to use the remaining funds in another investment.
Two more numbers you’ll want to run are the cap rate and cash-on-cash returns. Take a look:
The Cap Rate
The cap rate is the return that you’ll generate if you paid for the property up front in cash.
To discover the cap rate, take your net income and divide it by the property’s cost.
Annual income / purchase price = Cap Rate
Cash-on-Cash Return (CoC)
Finally, we have cash-on-cash returns. This figure is important if you’re looking to finance the property. The COC are the returns you’ll get on the money you’ve invested.
Here’s the equation:
Annual Income / Money Invested = Cash-on-Cash Return
What’s a Good Return on Investment for Real Estate?
It really depends on your investment goals, your priorities, and risk tolerance. It also depends on the market you’re investing in, and the projected appreciation for houses there.
Most investors are looking to match or beat stock market returns. If you consider that the historical average ROI on the S&P 500 is 10%, then you may want to look for property that will produce a similar return. This is a good benchmark to see if a property is worth investing in or not.
Don’t Forget About Property Appreciation
But ROI doesn’t JUST come in the form of cash flow, another important consideration when assessing a property’s returns is the projected appreciation; how much the home will increase in value. When it comes to investing, you’ll want to determine whether you’re investing primarily for cash flow or appreciation, or both. This will help to guide your decision when it comes to finding a market to invest in. Many markets either experience high appreciation and lower net cash flow, or they offer excellent cash flow returns, but not much appreciation. Of course, there are some markets where you can expect to get both. In addition to how you structure your loan, another way to improve your ROI is to buy a value-add property, that is, one that’s in need of repairs. This can allow you to get your foot on the investment property ladder in an area that’s expected to experience growth, and your returns will then be higher as well.
Choosing the right property is key to successful investing. Taking the time to look at the numbers and to study the potential value of a property helps you easily select the best properties that will meet your needs: whether you’re looking to create generational wealth, build your portfolio, or to have a long-term source of passive income. Just make sure you’re clear on what you’re looking for first so that you can ensure that you only put your money into property that meets your standards and generates the returns that you’re looking for.
Need help ensuring that your next investment is the right choice for you? Our portfolio services team can help. Get started by obtaining your free portfolio evaluation, and make sure your investments are working for you.
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