How to Calculate ROI in Real Estate Investments

A big motivation for many investors who get into real estate investing is to increase their wealth and diversify their investment portfolios. Real estate primarily refers to tangible assets that provide inherent value in the form of land, buildings and properties. Unlike other investment options like stocks or bonds, real estate can include physical assets that can be utilized, rented or sold.

For some investors, they acquire real estate assets with the intention of making money through rental income while others acquire property with the intention of selling it after a short time.

Regardless of the investor's motivation, to truly maximize the potential of real estate investments, it is essential to have a clear understanding of the return on investment (ROI), a fundamental metric that measures the profitability of an investment. That way, investors can be able to gauge profitability of their investment properties.

As an investor, it is crucial that you consult a financial advisor and real estate professional professional when evaluating the return on investment (ROI) of real estate investments. This is because these professionals can provide guidance on how the investment aligns with your financial goals and help you create a well-rounded investment strategy.

Key Takeaways

• Return on Investment (ROI), in real estate refers to the profits that have been generated by an investment property, as a percentage of its total cost
• ROI is a fundamental metric that is used to measure the profitability of a real estate investment
• To calculate the ROI of an investment property, take the net profit, subtract the original cost of the investment and then divide that by the original cost
• As a real estate investor, it is crucial that you consult a financial advisor and real estate professional when evaluating the return on investment (ROI) of real estate investments, as these professionals can provide you with valuable insights

Disclaimer

The contents of this article are for educational purposes only. They are not intended to be a source of professional financial advice. You will find experts on financial planning and financial management here. More on disclaimers here.

What is ROI in Real Estate?

Return on Investment (ROI), in real estate refers to the profits that have been generated by an investment property, as a percentage of its total cost.

It is an important metric that helps investors to assess the profitability of their real estate investments. By comparing the returns generated to the initial investment, investors can determine whether the investment is generating a satisfactory return.

How to Calculate ROI in Real Estate

To calculate the ROI of an investment property, you take the net profit, subtract the total investment cost and then divide that by the total investment cost.

For example, you may purchase and revamp a property at $5,000 and then later sell it at $7,000. The net profit made in that case is ($7,000 - $5,000) = $2,000.

To calculate the ROI, you take the (net profit) $2,000 ÷ $5,000 (original cost) = 0.4 which is equivalent to 40%.

How is ROI Calculated for Real Estate Investments?

While ROI may sound like a complex concept, the basic formula is net profit minus original cost divided by the original cost.

Variables that can affect this calculation include: The total investment cost (including acquisition and ongoing expenses), holding period of the property, financing costs, repair and maintenance costs, property appreciation and cash flow.

These variables play a significant role in determining the ROI and should be carefully considered to accurately assess the profitability and performance of real estate investments. By taking these variables into account, investors can make informed decisions, compare investment opportunities and optimize their returns in the dynamic real estate market.

Here are some common real estate transactions where ROI is used and how you can account for these variables in your calculations.

Cash Purchase and Resales

In this case, a real estate investor can purchase a property with the intention of flipping it or a foreclosure house. Usually they don't pay any mortgage as it's a cash sale.

So if the investor purchases the house at $50,000, repairs it and spends $20,000 and then later sells it at $100,000, their ROI will be 42.85 %.

ROI = Net Profit ($100,000) - Total investment cost ($70,000) ÷ Total Investment Cost ($70,000)

Rental Property

To calculate the ROI for real estate rental property, first start by estimating your average annual rental income. To get this figure, take the monthly rent that you charge and then multiply that by 12 months.

Next is for you to determine the property's net operating income (NOI) by subtracting operating expenses from rental income. Operating expenses may include things like maintenance, insurance and property taxes.

Then, cash flow is calculated by subtracting mortgage payments and non-operating expenses from the net operating income. The total investment includes all costs associated with acquiring and improving the property.

To calculate ROI, divide the annual cash flow by the total investment and express it as a percentage. Consider the holding period to estimate the overall ROI. It's important to consider other factors such as property appreciation and tax benefits, and regularly review and update ROI calculations to assess the rental property's performance and make informed investment decisions.

REITs

If you're looking to invest in real estate passively, then REITs are a great option for you. To invest in REITs, you can buy shares on major public exchanges. With an average annual return of 12%, REITs offer a good way to generate steady income and diversify your investment portfolio.

Generally, What is Considered a Good ROI for Real Estate Investments?

The definition of a good ROI for real estate investments can vary depending on various factors, including market conditions, investment goals and risk tolerance. However, as a general guideline, a good ROI for real estate investments is typically considered to be higher than the average return offered by alternative investment options.

While specific benchmarks may differ, many real estate investors aim for a ROI that surpasses their cost of capital or exceeds the average annual return in the real estate market. Some investors may target a specific percentage, such as a double-digit ROI, as their desired threshold for considering an investment successful. Many real estate experts agree anything above 8% is a good return on investment. However, it's good to aim for 10% and above.

It's important to note that what constitutes a good ROI can also depend on the type of real estate investment. For example, a rental property investment may have a different target ROI compared to a fix-and-flip project or a commercial real estate venture.

Therefore, investors should consider the risk associated with an investment when assessing the ROI. Higher-risk investments may require a higher potential return to justify the additional risk. It is advisable for investors to conduct thorough analysis, research market trends, and consult with a financial expert and real estate professionals to set realistic ROI expectations and align them with their investment goals.

The Importance of ROI on Real Estate Investments

ROI (Return on Investment) holds significant importance for real estate investments due to the following reasons:

Performance Assessment

ROI provides a clear and quantifiable measure to assess the financial performance of real estate investments. It helps investors determine how effectively their capital is being utilized and whether the investment is generating desirable returns. By calculating ROI, investors can evaluate the success and profitability of their real estate ventures.

Investment Comparison

ROI enables investors to compare different real estate investment opportunities. By calculating and comparing the ROI of various properties or projects, investors can make informed decisions about where to allocate their funds. It allows them to prioritize investments with higher potential returns and select the most lucrative opportunities.

Risk Evaluation

It also helps investors evaluate the risk associated with real estate investments. A higher ROI generally suggests a higher potential return on investment, but it may also indicate higher risk. By analyzing the ROI alongside other risk factors, such as market conditions, location and property-specific considerations, investors can assess the risk-reward ratio and make more informed investment decisions.

Financial Planning and Strategy

By understanding how ROI works, investors can then set realistic goals and benchmarks for their investments. By monitoring ROI over time, investors can track the performance of their portfolio and adjust their strategies accordingly. ROI provides a basis for setting investment targets, determining holding periods and planning exit strategies.

Decision Making

ROI is a key factor in making crucial decisions regarding real estate investments. It helps investors decide whether to acquire, hold or sell a property. A low ROI may indicate the need to reassess the investment or implement strategies to improve returns. Conversely, a high ROI may signal an opportunity to exit the investment and reinvest in more profitable ventures. ROI serves as a valuable decision-making tool in optimizing investment outcomes.

Investor Confidence and Communication

ROI serves as a standard metric for evaluating real estate investments, making it easier for investors to communicate and compare investment opportunities. Clear and transparent ROI calculations enhance investor confidence and facilitate discussions with lenders, partners or other stakeholders. It allows investors to convey the financial viability and attractiveness of their real estate investments.

Conclusion

ROI is a key metric to consider in real estate investing as it provides a measurable and standardized way to assess performance, evaluate risk and make informed decisions. By considering ROI, real estate investors can optimize their investment strategies and strive for profitable and successful ventures in the dynamic and competitive real estate market.

Bay Street Capital Holdings

Bay Street Capital Holdings is an independent Black-owned investment advisory and wealth management firm that is based in Palo Alto, CA. Founded by William Huston after 13 years of supporting the United States' largest retirement plan ($650B) Thrift Savings Plan, Bay Street was founded to advocate for diverse and emerging fund managers and entrepreneurs.

In 2021, William was recognized as Investopedia’s Top 100 Financial Advisors. Bay Street was also selected as a finalist out of over 900 firms across the US in the category of Asset Manager for Corporate Social Responsibility (CSR). In California, only two black-owned firms out of nineteen firms received this recognition.

Bay Street works to manage portfolios with the goal of maintaining and increasing total assets and income with a high priority on managing total risk and volatility.

Sources

https://www.investopedia.com/articles/basics/11/calculate-roi-real-estate-investments.asp

https://www.rocketmortgage.com/learn/roi-real-estate

https://bungalow.com/articles/a-beginners-guide-to-calculating-roi-on-an-investment-property

https://moneytips.com/what-is-roi-in-real-estate-and-how-to-calculate-it/