Understanding the concept of Return on Investment (ROI) is essential for every investor. It is a term that is used to indicate how much money you will get back from an investment after accounting for all of the expenses. It is expressed as a percentage of the original investment cost, and is one of the simpler metrics used when evaluating real estate investment. The important thing to keep in mind though, is that a true ROI figure must account for all associated costs you incur as part of your investment.
ROI is mostly used for transactional type investments, such as a fix up and flip. If you are acquiring a rental property, use the Cap Rate instead. It is similar to ROI, but accounts for other details you have with buy and hold type real estate. If you’re buying a property for the short term, with the intent of selling, continue on to calculate the ROI.
Gather the information:
Before calculating the ROI, you should gather all the related information. This includes the purchase and sale price amounts, and your costs, such as closing fees, insurance, taxes, commissions, repairs, and maintenance.
Calculate the ROI:
For calculating ROI, you need to follow these steps:
- First, add up all of acquisition costs, including the purchase price and any closing expense you had. Any easy way to do this is to reference the Settlement Statement from your closing.
- Next, add up all the expenses related to holding and improving the investment. Make sure you include interest payments and utility expense as well.
- Add up all of the sale expenses, including commissions, title agency fees, local taxes, etc.
- Take the figures from the first three bullets, and add them up- this is your total amount invested.
- Now, subtract this amount from the sale price (when you sell), this is your net return.
- Now that you have the net return, divide it by the total amount of investment (bullet 4). You should end up with a decimal like .15 or .20.
- Convert the decimal into a percentage, like 15% or 20%, this is your Return on Investment (ROI).
- Purchase price is 100,000, and closing costs at time of acquisition are 5,000. Total of 105,000.
- Repairs are 20,000, plus 3,000 in holding costs, for a total 23,000
- Sale commissions are 18,000, and other sale expenses of 3,000, for a total of 21,000
- Add up all of the costs (105,000 plus 23,000 plus 21,000) equals 149,000.
- Sale price is 175,000, minus 149,000, equals 26,000
- 25,000 divided by 149,000 equals .17
- Converted to a percentage is 17%. In this example, our Return on Investment is 17%.
One of the best things about using ROI is that you can use it to compare multiple investments, even if they are different in nature. While it’s not the only tool you should use, it is one of the most important.
One side note to mention, in the example we shared above, we have not taken capital gains taxes into account. As you get more advanced in your investing activities, this is another expense you should consider.
There are many other metrics you can use when evaluating real estate investments, but this is the one you should learn first. Once you are comfortable with this one, look at Cash on Cash return next.