Return on Investment (ROI) is a performance measure used to evaluate the efficiency or profitability of an investment. In real estate, the ROI gives investors an idea of how much they are making on their investment compared to the cost of the investment.
Here's the basic formula for calculating ROI:
ROI = (Gain from Investment - Cost of Investment) / Cost of Investment
In real estate investing, it's essential to understand that the "Gain from Investment" and "Cost of Investment" can include several factors.
- Gain from Investment: This includes the rental income generated by the property and any appreciation in the property's value and tax benefits such as depreciation.
- Cost of Investment: This includes the purchase price of the property, any rehab or renovation costs, closing costs, and ongoing expenses such as property taxes, insurance, and maintenance.
For example, you purchase a property for $100,000 and spend an additional $20,000 on rehab costs and closing fees. So your total initial investment is $120,000.
You then rent the property for $1,200 monthly or $14,400 yearly. After deducting $4,400 for annual operating expenses and mortgage payments, you have a net annual income of $10,000.
Additionally, the property appreciates by $5,000 over the course of a year. So your total gain from the investment in the first year is $10,000 (income) + $5,000 (appreciation) = $15,000.
Your ROI would then be calculated as follows:
ROI = ($15,000 - $120,000) / $120,000 = -87.5%
This might initially seem alarming, but remember that real estate is typically a long-term investment. You usually only calculate ROI after one year, but over many years or when you sell the property.
Remember that ROI is just one metric, and looking at others like cash flow, cap rate, and cash-on-cash return is essential. ROI can give you a big-picture view of the potential profitability of an investment. Still, it's important also to understand the specific sources of income and costs associated with the property.
Next Up ... Your Comprehensive Guide to Understanding Gross Rent Multiplier (GRM) for Real Estate Investors