When we talk about real estate investments, investors are concerned about the ROI calculations. Real estate is a lucrative business, but you can make a decent profit if you invest wisely. ROI is important to maintain cash flow. However, new investors have no idea about ROI and calculating it. This article will help you to understand the basics of ROI.
What is ROI?
ROI stands for Return on Investment. Investment is the basic resource of any company. It is used to acquire new products for the company or improve the organization’s performance. In most cases, time and money are the resources, but resources may vary from organization to organization. The profit obtained from a particular business is called Return on Investment or ROI.
It is the value of an investment against the cost invested in this business. In simple words, it is the calculation of how much money you will make for your investment. The formula of ROI is simple i.e.
ROI: (Profit – Cost)/ Cost
For instance, if your initial investment for a business was $2,000 and you made $20,000 from it, your ROI is 900%. We can easily calculate it using the formula mentioned above.
Why ROI is important for real estate investors
If you are a new investor, you may wonder about the importance of ROI. It is important to understand why ROI is vital for investors. People invest in real estate to make good money. Every investor wants to make money for their investment. ROI gives them an idea that how much they can make from the money they have invested in the business. It helps to make your budget, and you can plan the profit you will make.
If you know your ROI, you know the expenses, and you can also estimate the income. It helps you to make investment property analysis simpler. In 2022, it is more important as housing marketing is going back to normal after the pandemic.
How to Calculate ROI in Real Estate?
If you know the formula to calculate ROI, you can calculate it easily. We have mentioned the simple formula above. Here we are discussing different aspects of ROI calculations.
Cash Transaction ROI
ROI Calculation depends on the type of transactions. If you have made transactions in cash, you can calculate it with a simple method.
Assume that you have paid cash of $100,000 for a real estate property. You have paid another $1,000 as closing costs. You have used $9,000 for improvement as well. The total investment for the home is $110,000 now. Now you are renting out your property for $1,000 per month. The aggregate for the year will be $12,000. But you have to pay some expenses like property tax, insurance, and maintenance costs. Suppose the total of these expenses is $2,400 per year. In the end, the annual return for the investment is $12,000 - $2,400 = $9,600.
So if cash is involved, you can calculate your ROI with the given formula
ROI= Profit – Expenses/Cash Investment cost
Based on this formula, the ROI is 8.7%.
Financed Transaction ROI
Every investor doesn’t work with cash; some people take loans from financing agencies to start their real estate business. The calculation of financed transaction ROI is different if we compare it with cash transaction ROI. The following example can help you to understand it.
Suppose you want to purchase a property worth $100,000, but you have decided to take a mortgage instead of paying cash. The first thing you have to consider in this situation is the down payment for the mortgage. Next comes the closing cost and cost of repairing the unit. Assume that the down payment is 20% of the purchase price; if the total cost of the property is $100,000, the down payment with be $20,000. For mortgaged properties closing costs are also higher than for cash properties. It can be as high as $2,500. Next comes the repairing cost, $9,000. The total expenses will be the sum of these costs, and the aggregate is $31,500. You may need to add the costs associated with a mortgage as well.
Suppose you have taken a standard fixed-rate mortgage for 30 years, and the interest rate is 4%. After the down payment, you have to pay $80,000, and it will be $382 per month. Add your monthly expenses of $200 in this amount, and the total becomes $582. Now you rent out your unit for a monthly rent of $1,000. You can calculate cash flow by deducting expenses from income, and it will be $418 per month and $ 5,016 per year.
ROI = Annual Cash flow/ expenses
So your ROI is 15.9 % per year.
Difference between Cap rate and cash on cash return
When we talk about ROI, terms like cap rate and cash on cash return are commonly used. Most investors use them interchangeably, but actually, they are different. The difference is more obvious if we have to calculate ROI. It is very important to differentiate between the two, particularly if you are investing in rental property as an investor.
The Cap rate is simple to calculate. It is about the property's net operating income divided by the property's purchase price. It can help you project ROI; however, it does not consider financing methods. If you have mortgaged your property or taking a loan, there can be problems in the calculation.
The metric used to calculate ROI is called cash on cash return. It considers the financing method as well. It used pre-tax net profit and divided it with the total cash price of the property. This is commonly used to calculate profitability.
Other than these, you can find investment property calculators as well. They use the market data and other investment tools to calculate ROI. You need to provide the property's price and other expenses; the calculator will do the rest of the job for you. These calculators are easy to use; however, you have to choose a reliable one.