Real Estate ROI Calculations made easy

This Real Estate Return on Investment (ROI) breakdown is focusing on residential single family homes in an effort to make it easy.

I want to make special mention that when determining other assets’ returns versus real estate returns one needs to take into account that different rules apply to different asset classes.

Furthermore, I would caution those who invest in stock via a broker or through an employer that you take a good look at the numbers and not take their “word” for how your accounts are performing. I’ll touch on this a little later in this post.

When dealing with ROI in real estate investments one also needs to be aware that there are sub niches of investing that are also governed by unique rules and laws.

We will not be going into all of these but the calculations are similar. The best practice is the old adage of compare apples to apples or oranges to oranges.

We need to be careful that we don’t offer unfounded criticism or make unwise financial choices when investing.

Figuring your ROI is not difficult so you won’t need a real estate ROI calculator. Just a little time with a pen and paper will do the trick!

Before we get started please note this DISCLAIMER!

This is my personal opinion about how to calculate your return as an investor; and since I am not a CPA, lawyer, or otherwise legal professional this opinion is “unqualified”. This is simply how real estate ROI makes sense to me. I have not included tax savings, depreciation, inflation etc. as that will be different for everybody.

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Certificate of Deposit (CD) rate of return

You place $100,000 in a CD at 2% annual return. This means your money is growing 2% annually, otherwise stated, this is your annualized ROI.

Your contract then matures and is now time to cash out or liquidate the CD account. You get your original $100,000 plus the 2% interest you had earned.

Calculation:

Interest amount earned is divided by the number of years earned. This is then divided by $100,000. The result would be your annualized ROI for this type of investment or how much it grew on average annually.

Numerical example:

You had the CD for 2.5 years and the amount of interest was $5,000.

Interest earned ($5,000) / # of years invested (2.5) = $2,000 return per year. $2,000 / capital investment ($100,000) = 2% annualized ROI.

Unlike fixed CD rates, other investments like stocks, bonds, real estate, etc. we do not know the ROI at the start. We won’t know the full ROI in advance since the profits come later and vary depending on the market.

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Apples to Oranges?

 

Be careful what stock brokers quote you concerning your returns in the stock market!

What they may tell you:

You invested $100,000 in stocks and the first year you lost 30% and in year two it climbed 12% followed by an additional 18% growth in the third year.

Your stockbroker would say you averaged 0% annual return, or “broke even” since the average of these percentages is zero.

What actually happened:

The stocks lost 30% in the first year so your 100k is now worth $70,000 at the beginning of year two. In year two your funds grew 12% and is now valued at $78,400. In the third year it grew another 18% making the balance $92,512.

You see, the growth is occurring on the current value of  the portfolio NOT the original amount of $100,000.

OUCH! Your broker told you that your principal was earned back, but you’re still in the hole! This is how stock returns can be misleading.

To avoid this painful and costly situation simply follow the formula described above.  How much did I put in? How much did I get back annually? Now divide that by how much I put in etc.

It’s essential to compare apples-to-apples so you make the right decisions with investing.

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 Real Estate ROI Examples

Leveraged Example

Let’s say I buy an investment property for $100,000 with a 20% down-payment which is $20,000. I also have rehab, closing costs, setup etc. that total $12,000.

This brings my total capital investment to $32,000. This is how much money leaves my account to fund this investment.

Remember with real estate there are several profit centers.

1. Cash-on-Cash ROI is how much money you actually get every year that you own the property. It’s based on your monthly or annual cash-flow.

This property rents for $1,000 monthly. After all the regular monthly expenses (HOA, property management, mortgage, mortgage insurance etc.) I have $300 leftover.

Even though I’m getting $300 monthly I factor 10% of my gross rents ($100 monthly) towards potential vacancies and repairs. So I consider my net cash flow to be $200.

I figure out my annual cash-flow is $200 x 12 = $2,400 annually. This is the “interest” I am earning on my principal/capital invested.

Annual cash-flow is $2,400 divided by my capital investment of $32,000 = 7.5%. Therefore, my annualized cash-on-cash ROI is 7.5%.

This could actually be better than a 7.5% CD because the profits from a CD are fully taxable whereas cash-flow from real estate is actually offset by tax write-offs and deductions against the property which make it look like you are losing money on paper to the IRS!

2. Gain on Sale is pretty obvious. It’s simply how much money after expenses you make once you sell the property which includes paying off the mortgage and reimbursing your initial capital investment of $32,000.

I sell the house after 5 years of ownership for enough that after all my selling costs and other dues I clear $150,000.

My mortgage loan is paid off automatically.

Let’s assume the remaining balance due is $78,000. It was $80,000 at first, but my tenant’s rent over five years has whittled it down some.

So I sell the house and get a check from the title company for $72,000! Pretty exciting, but this is not all profit.
I reimburse myself $32,000 for the initial capital investment so now my actual profit was $40,000. Still not bad!

My annualized return on equity or the difference between my purchase price and my selling price, I take$40,000 net gain on sale divided by $32,000 capital investment and this gives me 125%. This is my total ROI on equity for this property.

Now take the 125% divide it by the number of years that I held the property which is 5 years and that comes to 25% annually. Therefore, my annualized equity ROI is 25%.

These two profit centers, cash-flow and return on sale, are the largest. I can add the two, 25% + 7.5%, and get 32.5%. Therefore, my money is growing at 32.5% annually! Compare that to the CD or stocks!

If you are doing a Lease Option then there is an additional profit center to add. This will only apply if the tenant defaults and the up-front nonrefundable option payment money can then be considered extra cash-flow.

If it does go through, and we want it to, then it should “net out” because we will be giving it back to the tenant in the form of a discount when they purchase the home.

Of course there are tax benefits which are additional perks with real estate investing. Your CPA can tell you all about it and calculate it for you. These tax breaks or write offs add to the returns calculated above.

All Cash Example

Again our purchase price is $100,000 plus $8,000 in other up-front costs. This is lower because we didn’t have to pay any financing costs. Our total capital investment is $108,000.

Our monthly cash-flow is more because we don’t have a mortgage payment. We net $700 which is $8,400 annually after monthly allotments for taxes, insurance, HOA, and property management fees.

This number looks great, but we need to divide it by our capital investment of $108,000 to get our annualized cash-on-cash ROI which comes to 7.8%. Almost exactly the same as if we had financed the property.

We sell the property in 5 years for $150,000. We reimburse ourselves the $108,000 we invested. Now we have $42,000 net gain.

$42,000 / $108,000 = 38.9% This is our total equity ROI. Divide this  by 5 years and we get 7.8% annually. Surprisingly it is the same percent as our cash-on-cash scenario.

We add the 7.8% cash on cash to our total equity of 7.8% which makes our total annual ROI 15.6%.

This is a great return, but it’s only ½ as much as we would have made financing or leveraging the property!

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Soap Box Warning!

I have met a few die hard folks who believe ANY type of debt is morally wrong. I don’t hold that view.

Instead I choose to educate myself and surround myself with experts so that I can wisely manage and mitigate the risks associated with performing debt while maximizing my returns!

This is why we finance or leverage properties whenever we can; because we make a better return on our money! This is what the “gurus” mean when they talk about using other people’s money or OPM.

Like I mentioned above it is critical to understand this so you can compare different forms of investments.

The higher the ROI, the faster you grow towards financial independence, and more passive cash flow in the meantime.

Real Estate ROI Calculations By Joe Nielsen