Return on investment (ROI) is essentially a terminology that helps determine the actual return derived from a real estate investment. ROI is usually mentioned as percentage. Finding out the ROI of your real estate investment is vital to keep a tab on your investment’s performance, or when comparing multiple investments. ROI is calculated by subtracting the investment cost from investment gain, and then dividing the number by investment cost.
How to Calculate Real Estate Return on Investment
The calculation method may sound straightforward and easy, but that’s not really the case since several variables including maintenance and repair expenses and techniques to figure out leverage have to be considered, which could affect the final ROI. In several cases, ROI would be greater if the investment cost is lower. When buying property, the financing terms significantly influence the investment price. But using resources such as a mortgage calculator could help save money on the investment cost by assisting you discover favorable rates of interest.
ROI can be calculated through the following two methods:
• Cost Method
This method computes ROI by incorporating all costs to divide equity. For example, a property was purchased for $100,000. After all the property rehabilitation and repairs, which sets the investors back by an extra $50,000, the property valuation is $200,000, which means the equity position of the investors in the property would be $50,000 (200,000 – (100,000 + 50,000)). The cost methodology needs the equity position to be divided by all costs pertaining to the purchase, property rehab and repairs. In this example, the ROI is .33 percent – $50,000/ $150,000.
• Out of Pocket Technique
This technique is usually preferred by investors since it offers higher ROI results. Taking the numbers from the aforementioned example, let’s assume the property was bought for the exact same price. However, the purchase this time was financed by a $20,000 down payment and a loan. Therefore, the out of pocket cost is just $20,000, with $50,000 for rehab and repairs, for a complete out of pocket cost of $70,000. With the property value at $200,000, $130,000 would be the equity position. In this example, the ROI is .65 percent – $130,000/ $200,000. The outcome is just a percent lesser than the double of the first example.
Equity Doesn’t Equate to Cash
Before you learn how to calculate real estate return on investment, you must know that a property should be sold to realize its ROI in true cash profits. Generally, a property won’t sell at its real market price. Often, the deal would be consummated at a price lower than the price initially asked, decreasing the property’s final ROI calculation. Also, you must know there are expenses connected to a property sale – again, there could be expenses required for painting, landscaping, or repairs. The property’s advertising costs must be added up too, in addition to the appraisal costs and broker commission.
Both commission and advertising costs could be negotiated. Property developers, who have multiple properties to promote and sell, are usually more forthcoming about negotiating rates with brokers and media outlets. However, the ROI on several sales with varying expenses for commission, advertising, construction and financing present complex accounting problems that could be best handled only by an accountant.
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