Return On Investment

The return on investment (ROI) is a measure of how much money, or profit, is made from investment relative to its cost. This metric measures how well you are using your investment dollars. It is important to understand what ROI means and how to calculate it in real estate.

Complications in Calculating the ROI

The financing terms that you choose to finance your property purchase can significantly impact the final cost. Refinances and second mortgages can cause problems in the calculation of ROI. Refinanced loans or interest on second loans may rise. Loan fees can also be charged, which can lower the ROI.

You may also see increased utility rates, property taxes, maintenance costs, and property taxes. These expenses may be paid by the owner of a commercial property or residential rental. All these numbers must be entered to update the ROI.

Complex calculations might be necessary for property purchased with an adjustable-rate mortgage (ARM) - a loan with a variable rate over the loan term.

Let's look at two main methods of calculating ROI: the cost method and the out-of-pocket method.

The Cost Method

The cost method calculates ROI using the equity of a property divided by the property's costs.

Divide the equity position by all costs associated with the property's purchase, repair, or rehabilitation to use the cost method.

The Out-of-Pocket Method

Real estate investors prefer the out-of-pocket option due to its higher ROI.

What Is A Valid Return On Investment For Investors?

One investor may consider a good ROI, while another might not. The best ROI for real estate depends on your risk tolerance. The higher the risk, the better ROI you can expect. Risk-averse investors might be willing to accept lower ROIs in return for greater certainty.

However, investors generally aim to achieve returns comparable or greater than the S&P 500 in order to make real estate investing worthwhile. The historical average S&P 500 return was 10%.

You don't need to own any property in order to invest in real estate. REITs, or real estate investment trusts, trade on the same exchanges as stocks. They can provide diversification and income without having to manage any property. Because REITs trade on an exchange, they are generally more volatile than physical properties. The annual return for REITs in the United States is 12.99%, according to the MSCI U.S. REIT Index.

Return On Investment Does Not Mean Profit

The property must be sold before the ROI can be realized in cash profits. A property may not sell for its market price. Real estate deals may close at a lower price than the original asking price. This reduces the property's final ROI.

There are also costs associated with selling real estate properties, including painting and repairs. You should also add the appraisal costs as well as the commission paid to the broker or real estate agent.

The service provider may negotiate both advertising and commission costs. If you have multiple properties to sell and advertise, real estate developers are more likely to get favorable rates from brokers and media outlets. However, multiple sales can have a complex ROI. There are varying costs for financing, commission, and advertising.

The Summary

Depending on the variables, calculating ROI for real estate is either simple or difficult. In a strong economy, investing in real estate --both residential and commercial----has been very profitable. Investors with enough money can find bargains on real estate even in recessions. Many investors can make a good profit when the economy recovers.

Before filing, real estate property owners should seek professional tax advice from a trusted source for income tax and capital gains tax purposes.