Return on Investment (ROI) In Real Estate & how to calculate ROI

All investments, such as stocks, bonds, or real estate, aim to make money and wealth after a certain period. If you can accurately calculate the potential profits from investing in a property before owning or acquiring it, you are more likely to succeed in making profits. And one of the best indicators investors use is a return on investment or ROI. If you don’t know what ROI is or does, follow along.

What is ROI in Real Estate

Return on investment is the ratio of the profits to the costs of an investment. ROI measures how much money is made on an investment as a percentage of the investment’s price. Investors use this to evaluate the profitability of an investment. Calculating ROI on a rental property is essential. The return on investment represents the potential of income-generating assets. Investors who have a general idea of the Rate of return can decide whether investing here is worth it. A higher ROI means your profits will be in your cost’s favor.

Not all homes or properties for sale have the same probable profits as rental properties. A beginner should use the ROI calculation when planning to buy their first rental property to compare investment opportunities that are available in the market. By calculating ROI on investment opportunities, new investors can make intelligent decisions. Seasoned real estate investors also use ROI to compare different investment portfolios.

How to calculate ROI in real estate

Now that you have an idea of ROI, you need to know the steps to calculate the ROI. Here’s how you can do it:

1. First, estimate how much you would spend on renovating the rental property you invest in for a year. Calculate the yearly rental income by multiplying the monthly income by 12.
2. After calculating the yearly income, it’s time to subtract expenses you expect to incur (mortgage payments, repairing). The result of the subtraction is the cash flow.
3. Every payment that contributes to the mortgage principal will increase your property’s equity. Calculate the equity and add it to the cash flow you’ve just calculated. This generates your net income from the investment.
4. Now, follow the ROI equation and divide the net income by the total cost you paid for the investment. Follow this equation to get the ROI

ROI = (Gain in Investment - Cost of investment) / Cost of Investment

Limitations of ROI calculation

However, there are some limitations to the ROI calculation. While calculating the investment return is easy, some expenses can impact the ROI. These include maintenance, repairs, taxes, etc. Another thing that affects the ROI calculation is the investment financing method and financing terms. Considering these complications, experts don’t recommend using the ROI formula only when calculating your profits. For accurate profitability, two methods can be applied.

1. Calculating Cap Rate, The Cost Method

The cost method in real estate helps the investor calculate a more accurate ROI for transactions done by cash. The formula for calculating ROI is dividing the property’s net operating income by the costs related to the property purchase. Follow this equation:

Cap Rate = (Net Operating Income / Total Investment) x 100%

2. Calculating Cash on Cash Return, The Out-of-Pocket Method

The out-of-pocket method calculates the cash-on-cash return when calculating real estate ROI with mortgage-financed transactions. You need to list the monthly interest you pay in your expenses when you buy an investment property with a loan. Dividing the annual return by the total cash invested should do the trick. Calculate the cash on cash return like this.

Cash on Cash return = (Annual Return / Total Cash Invested) x 100%

Related FAQ

What does ROI mean in real estate?