If you have considered joining the real estate industry, it would be best if you familiarize yourself with a few key terms. One would be your Return on Investment or ROI. When you work with rental properties, you can't go too long without hearing that term. Yet, what exactly does it mean? Plus, more importantly, how do you calculate it?
- What Is Return on Investment: It is a method of calculating your profit in relation to the overall amount that you invested.
- The Importance of ROI for Real Estate: A higher ROI means you are earning more every dollar you invest. Therefore, your profitability is better if your ROI is higher.
- Numerous Factors Influence Your Final ROI: To account for profits accurately, you'll need to track them all.
The Importance of ROI for Real Estate
Before we look at how to calculate your ROI, let's talk about why you should want to in the first place. Typically, people get into the real estate market because they want to earn a profit. They worked hard for their money. Now, it is time for their money to work hard for them. ROI is an easy way to conceptualize how hard the money is working for you, so to speak.
What is Return on Investment
Now, let's get technical with the definition. The return on your investment is a figure that represents the total profit in relation to the initial expenditure.
A Measure of the Profit From an Investment:
The more you earn, the higher your ROI. The less you spent initially, the higher the ROI. Hopefully, you get the picture by this point. Let's say you put a smaller amount into one property than you did another. If that is the case, then as long as they generate equal revenue, the less expensive property will have the highest ROI.
Common to See in the Real Estate Industry:
Generally speaking, you can use this term to refer to any asset class. If it appreciates in value, then you can describe your earnings in terms of the return on your initial investment. However, it is, by far, most commonly heard in the real estate sector.
Why Does Your Return on Investment Matter?
Ok, so it tells you how much you are earning. Nevertheless, could you not do the same by looking at your bank account? Of course, you could calculate whether the investment is worthwhile using a variety of methods. However, this is a time-honored method with a very low barrier to understanding.
Determines Whether an Asset Is Worthwhile:
Suppose you have been sinking a lot of money into a property. At some point, you begin to wonder if it is even worth the effort. By using the ROI, you can determine whether it is or not. When the ROI drops negative, then you can assume the endeavor has lost its value.
Shows You Which Investments Will Earn You the Most per Dollar:
Who does not enjoy being efficient? If you would like to invest as efficiently as possible, maximizing your ROI is among the most effective ways for you to do so. The larger the return is, the more efficient the investment is.
Methods to Calculate Your Return on Investment
Now, it is time for you to learn how to calculate your ROI. Luckily, it does not require too much-complicated math. However, before proceeding further, you'll need to gather some important information.
Without this info, it will be impossible for you to do the calculations. If you do not have access to it at the moment, then go and retrieve it. Once you have it in your hands, you can move on from here.
Your Initial Investment:
The initial amount you invest will depend on the type of transaction you perform. Typically, we can assume you took out a mortgage to purchase the property. Nearly all home purchases are done with the assistance of finance. However, in the event you used cash, the algorithms will change slightly.
Your Yearly Revenue:
In the guide below, we will assume you are using rental income as the yearly revenue. To calculate your yearly revenue, simply multiply the monthly rent by the number of months the unit was occupied over the previous year. If the home was occupied for fewer than 12 months, then choose an appropriate number for your calculations.
There's a Difference Between Financing and Cash Purchases:
Depending on the method of purchase, the overall calculations will look very different. When you want to calculate the total initial investment, you should first determine whether you paid with a mortgage or cash. If you used cash, then you will include all the money you paid, including closing costs. On the other hand, for a mortgage, you will only include the downpayment and closing fees.
Return on Investment for Cash Purchases
Below, we have listed a step by step guide for the calculations. Once you complete them, you will receive a number in decimal format. From there, you can multiply that number by 100 to convert it into a percentage. In most instances, people find it easier to work with percentage representations rather than decimals.
Steps to Calculate Your ROI
- First, Take the Total Amount Invested: For a cash purchase, this will be the total value of the home plus closing fees. So, let's assume, after everything, you spent 120,000$ to purchase a property for this example.
- Then, Subtract That From the Gain on Your Investment: Now, for your gain, we will presume you rented the home for the entire year. For ease of calculations, let's say the amount you charged for rent was 1000$. That would mean you made 12,000$ total throughout the year.
- Remember to Include Monthly Expenses: We are going to guess you spent, on average, 300$ each month on various fees. Therefore, you spent a total of 3600$ on upkeep in the last year.
- Subtract Your Expenses From the Income: Now, take the 12,000$ you made from rental income over the year. Then, subtract the 3600$ you had to pay for upkeep from it. That should leave you with 8,400$ in profit.
- Finally, Divide the Result by the Total Initial Investment: Take the 8,400$ and divide it by your initial investment. In this example, that would be the 120,000$.
- Your Result Should Be in the Form of a Percentage: The result for this calculation should be 0.07. To convert that to a percent, simply multiply it by 100. That would give you a 7% ROI on your investment for this property.
Return on Investment for Financed Purchases
Since the majority of the calculations are identical for a financed purchase, we will not work through each step. To do so would be an exercise in tedium. Therefore, we will merely point out the areas where there are key differences.
Similar to the Method Above:
In general, you can follow the same steps as those listed above to calculate the ROI. When you calculate the monthly expenses for a financed purchase, you will need to also include the mortgage payment each month. On the other hand, you'll only have to use the downpayment and closing costs to get the initial investment.
Subtract Your Monthly Expenses From the Rental Income:
Now that you have gotten your preliminary figures, it is time to do some math. In this example, we will say your monthly expenses came out to be 600$ in total since you have to include the cost of a mortgage. The total amount you earn over the year will be the same as in the previous example, 12,000$. Therefore, your net earnings would only be 4,800$.
Divide That By Your Initial Investment:
For your initial investment, we have to make a few adjustments in this example. We will use the same overall home value of 120,000$ as we did previously. However, this time we will presume you spent a total of 30,000$ between your downpayment and closing costs. So, you take the 4,800$ and divide it by the 30,000$. That should give you a final result of 0.16. To convert this to a percentage, use the same method from the last example. Thus, your ROI, in this instance, would be a whopping 16% overall.
Factors That Affect Your Return on Investment
What else can affect the return on your investment? Depending on who you ask, you'll get plenty of various responses. Ultimately, what you decide to include in the equation beyond the basics is your choice. If you believe another factor should be accounted for, then, by all means, go ahead.
Should You Include Equity?:
The most common factor investors include in addition to those listed above would be the home's equity. Equity is a measure of the value you hold in the home above what you owe on it. So, if you owned a home that was worth 100,000$ while holding a mortgage worth 50,000$, then your equity would be 50,000$. Each time you make a payment on your mortgage, you build up a little more equity. Eventually, it can be quite substantial. Plus, you can leverage your equity for other investments. With the help of a financial institution, they can let you access that capital.
Repair Costs Should Be Considered
When you are looking at your monthly expenses, it would be foolish not to include the cost of maintenance. Even if you decided to neglect the maintenance, it would come back to haunt you in the long term.
Regular Maintenance Is More Affordable When Done on Time:
Caring for your property is much less expensive when you do not wait for emergency repairs. Thus, it is highly important for investors to set aside money each month to budget for possible repairs.
Fees Associated With Mortgages Need to Be Included
Suppose you financed the purchase of your rental property. If so, then you will have to include several additional costs with your monthly expenses. Otherwise, your calculations will fail to be accurate.
The amount you pay on interest will impact a variety of things. For one, it increases the size of your monthly payment. Additionally, it determines how quickly you build equity in the home.
Does the home reside in a neighborhood with an HOA? If so, then you need to put those fees into the math. If you do not, the final result will be imprecise. Follow the same line of thinking. For any other regular costs associated with your investment, throw them in the math.
How to Maximize Your Return on Investment
At this point, you should have a fairly decent grasp of the basics of this concept. Thus, we can begin to discuss strategy. Within real estate circles, professionals discuss how to improve their ROI endlessly. Ultimately, there are a few tips that seem to be effective in general.
Financing Vs. Cash Payments
When you want the highest ROI possible, you should go with a financed purchase. Of course, this will make your monthly cash flows look a lot different. Nevertheless, when it comes down to it, you'll have a higher return with a mortgage.
The Less You Pay Upfront, The Higher the ROI:
“Why is that,” you ask? Well, it is quite simple, really. When you use a mortgage, the size of your initial investment is much smaller. So, your return next to the initial investment is larger comparatively.
Keep Your Home's Occupied Year round:
As a final word of advice, do everything within your power to keep your units occupied. Even a single month without a tenant can impact your total return drastically. Vacancies could turn the investment from something profitable into a lost cause.