Running through the financial calculations on a property is a crucial step before the actual purchase. With careful calculations, you will know whether the property is a good investment or whether it will be a drain on your finances. While you cannot predict everything, you can discover enough to calculate a good estimate of income, expenses, and your return on investment (ROI).
Return on investment is a key financial measure of profitability used to measure the profitability of an investment or to compare investments. ROI is a basic ratio of the gain from the investment with respect to the cost, expressed as a percentage. While it is not the only metric used to evaluate a real estate investment, it is an important one
ROI % = (Net return on investment) / (cost of investment) X 100
How to Calculate ROI in Real Estate
In one sense, how to calculate real estate ROI is an incredibly easy task. At its most basic level, it’s simply defined as profit or income minus expenses. The calculation is rather simple: (Gain on Investment – Cost of Investment) / Cost of Investment
Another way to determine ROI real estate is as follows: ROI % = (Net return on investment) / (cost of investment) X 100
But while the math for determining real estate ROI isn’t complicated, you can still run into a lot of pitfalls while trying to tabulate your real estate return potential. For instance, consider that a particular property’s income isn’t fully comprised of your received rent. It may also include various fees you levy on the tenant for services provided and additional secondary income streams (e.g., laundry facilities, vending machines). Additionally, make sure to include all applicable expenses. We discuss these more in a following section, but some of these include:
- Property taxes
- Property management fees
- Maintenance and improvements
- Closing costs and other fees
- Pest control services
Failing to properly account for your expenses or income can cause you to dramatically underestimate real estate risk and acquire unprofitable investments.
Common Rules and Guidelines for Investing in Real Estate
Real Estate investors have developed a set of rules that help determine whether a property will be profitable, how much you should pay for the property, and the minimum rent you need to charge. Using these rules helps you estimate the basic financial potential of the property. Here are a few of the most common rules applied to real estate investments:
- 1% Rule –The 1% rule is a quick calculation that allows the purchaser to compare income to mortgage payments. It does not take maintenance and other expenses into account. (purchase price + cost of repairs) X .01 = minimum rent or max mortgage payment
- 2% Rule – A rough initial measure of the cash flow potential of a property. The guideline states that a property is usually a good investment if the rental income is above or equal to 2% of the purchase price: (monthly rental rate) / purchase price X 100 >2 %. If the % value is 2% or higher, the property is most likely to provide positive cash flow.
- 50% Rule – The 50% rule tells us to expect to pay approximately half of the income generated for operating expenses (not including the loan payment.)
- 70% Rule – This guideline for flippers states that the most you should pay for a property is 70% of the after-repair value minus the cost of repairs. Maximum purchase price = (After repair value x .70) – repair cost
These rules are general guidelines for real estate investment and do not tell the whole story. They are useful in the initial stages of investigating a potential real estate investment to determine whether it is worth further investigation. They are not a guarantee of profit since many more factors affect the investment.
What is a Good Rate of Return on Rental Properties?
There is no hard and fast rule on what is a good ROI on rental properties. Many variables are involved. For example, the size of the property, location, and associated risk all affect the acceptable ROI. In general, anything above 15% ROI is considered a great investment, and 10% or better is considered a good ROI on rental properties. In fact, most experts state that the average real estate ROI ranges from 9% to 10%, and average commercial real estate ROI often edges up to around 11%. Naturally, private equity real estate ROIs (i.e., REIT-like investments tailored for high-net-worth individuals that aren’t subject to certain regulations) are much more volatile and can include double-digit gains — or substantial losses.
Single-Family vs. Multifamily Real Estate Investments
Whether you should buy single-family properties or more substantial multifamily investments depends on your goals, your financial resources, and many other factors. It is usually easier beginning with single-family investments. They are easier to afford and finance as you build your portfolio and allow you to build home equity in addition to cash flow. However, multifamily investments usually generate higher incomes. Many investors start with a single-family investment, adding more houses to their portfolio as they are available and affordable. After they have gained some experience in real estate investment and dealing with tenants, they move up to multifamily investments. This can be an excellent way to build your portfolio without taking on too much risk in the beginning.
Factors and Considerations in Determining ROI
We have mentioned a few factors in determining ROI already, but let’s produce a more comprehensive list for consideration. While you will never be able to predict all associated costs in advance, you can prepare by being aware of the typical costs that real estate investors encounter regularly. These may apply to your property:
- Mortgage, property taxes, and insurance
- HOA fees
- Repairs and daily maintenance
- Property management fees
- Marketing fees
- Improvements to the property
As the owner, you are responsible for all of these costs. By planning ahead and considering them before you purchase the property, you will have a better idea of how valuable your property can be.
Limitations of the ROI Calculation
We already introduced one of the problems of using ROI to determine your profitability: Different people have different ways of calculating it that can lead to subtly different results. A related second reason is that individuals can sometimes define commonly understood concepts such as “profit” in multiple ways, making specific ROI results less than reliable if you don’t know the specific method by which they were determined.
A third issue with ROI lies in the fact that it completely ignores the impact of time. For example, an investment that garnered a 50% return over a six-month period looks identical on paper to one that realized a 50% return over, say, 10 years. But the elapsed period is anything but insignificant when choosing between different investments!
Finally, other metrics may be more applicable to your specific situation. Some of these may include:
- Determining your return on invested cash alone (Cash on Cash Return = Annual Pre-Tax Cash Flow / Total Cash Invested)
- Determining your return based on how much equity you have in the property (Return on Equity Real Estate = (Income – Expenses) / (Fair Market Value – Mortgage Balance)
- Determining your property’s value comparable to similar properties on the market (Capitalization Rate = Net Operating Income / Fair Market Value
- Determining whether or not a particular property will meet or exceed a desired return (visit Investopedia to learn how to calculate Net Present Value)
The Importance of ROI for Real Estate
None of those difficulties, though, negate the importance of using ROI in real estate contexts. Because a carefully determined ROI can easily conform to accounting measures, how to calculate rental income for taxes becomes just a part of calculating ROI. Also, because ROI is relatively easy to understand and to calculate, it’s more or less a standard measure in the industry. Are you wondering what is a good yield on a rental property? The answer you get will most likely be a ROI calculation. What about the average returns a rental property will produce? Again, expect to receive a ROI. In fact, in order to participate in real estate investment, this is one metric you absolutely have to know.
What Type of Real Estate Investment Has the Highest ROI?
As we’ve already discussed in a section above, the average real estate return on investment lands somewhere around 10%. Average returns rental property may tick higher or lower, as may investments in commercial sites and single-family homes. So while commercial properties may generally offer higher returns, you can’t exactly say that they have the “highest” ROI. In fact, the real estate investment with the highest ROI is always going to be that special deal that you somehow managed to discover, that bolt-out-of-the-blue opportunity that doesn’t just show up every day — and it could be anything.
If you need help finding these kinds of real estate investment properties or calculating any of these costs for your property, we would be happy to help. GNP Realty Partners is experienced in every aspect of real estate investment and management. Think of us as a partner with a passion for helping you achieve your investment goals. Call us today at 312-329-8400 or contact us to learn more about how we can help you.