How to calculate return on investment (ROI)?
“ROI is the most important thing you need to pay attention to,” assured Martin Chera on his last webinar at Real Estate IQ, “Rental 360”. The experienced lender and founder of Express Capital Financing explained in careful detail how to calculate return on investment for investors who choose to rent their properties. And, in case you missed it, we’re bringing the formula to you.
In general, “ROI measures how much money, or profit, is made on an investment as a percentage of the cost of that investment.” In other words, this is a critical number not only for you but also for your lenders because they will be able to find out if you’ll make enough money to pay them back.
Even though the formula Chera shared seemed quite simple, he advised not to be naïve. The thing is that many aspects can impact it, and therefore can affect your earnings. And this is both positive and negative. Some factors are going to decrease your profit, while others might increase it significantly.
“Our philosophy is to use other people’s money to invest. This way, you’ll get a higher return on investment more safely. Always use a lender to mitigate your risk by putting the least amount of money as possible,” he encouraged. And to prove it, he did the numbers for both scenarios.
How to calculate ROI?
To calculate ROI for a cash purchase, you have to take the net profit or net gain on the investment and divide it by the original cost. So, let’s say you paid $100,000 in cash for the rental property. The closing costs were $1,000, and remodeling costs totaled $9,000, bringing your total investment to $110,000 for the property (this is the second number you need for the formula).
Now, let’s suppose you collect $1,000 in rent every month. A year later, you would have earned $12,000. But we need to withdraw the cost of expenses (including water bill, property taxes, and insurance), which reached $2,400 for the year ($200 per month). That leaves you with an annual return of $9,600 (which is the first number you need for the formula). Now, all you have to do is divide the annual return ($9,600) by the total investment amount ($110,000). Therefore, your ROI was 8.7%.
However, if you ask for money elsewhere, the calculations get a bit complex. For the sake of argument, let’s maintain the example. You bought the same property for $100,000, but you took out a mortgage instead of paying cash. That means that the down payment needed for the mortgage was 20% of the purchase price ($20,000). Also, the closing costs were slightly higher – which is typical for a mortgage – and ascended to $2,500 upfront. You paid the same amount of money for remodeling ($9,000), making your total out-of-pocket expenses $31,500.
You also have to consider the ongoing costs that a mortgage has:
- If you took out a 30-year loan with a fixed 6% interest rate on the borrowed $80,000, the monthly principal and interest payment would be $479.64.
- In addition, let’s add the same $200 per month to cover water, taxes, and insurance, meaning that your monthly expenses are $670.64.
We’ll leave the rental income as it was ($1,000/month), which means your monthly cash flow is $320.36. Thus, one year later, you’d have earned $12,000 in total rental income, but your annual return would have been $3,844.32.
With these numbers in mind, to calculate the property’s cash on cash ROI, you have to divide the annual return by your original out-of-pocket expenses ($3,844.31/$31,500=0.122). In conclusion, your ROI is 12.2%. As you can see, in the second scenario, using other people’s money would have earned you a higher ROI without compromising your whole capital.
Bottom line, “the less cash paid upfront as a down payment on the property, the larger the mortgage loan balance will be, but the greater your ROI. Conversely, the more cash paid upfront and the less you borrow, the lower your ROI, since your initial cost would be higher,” Chera observed.
What variables can affect ROI calculations?
Both examples contain numerous items that have the power to affect ROI calculations. You can’t leave anything out of the formula in order to assess a deal as accurately as possible. Don’t forget that all these variables are expenses that you have to make anyway, so forgetting about them means less profit for you.
To make things easier, Chera enumerated them, so you can cross-check the list when running numbers:
- Equity – or the market value of the property minus the total loan amount outstanding.
- Repairs and maintenance costs.
- Vacancies – particularly in between tenants.
- The amount of cash you paid upfront – as was mentioned above, buying cash or taking a loan affects ROI calculations.
At the end of the day, “buying an investment property has many pros. You can use other people’s money to invest, and you reduce volatility – since you’ll never lose all your money in a property. Plus, it has unparallel tax benefits and appreciation potential; it’ll provide you with cash flow and with the ability to leverage assets for new ones”, Chera concluded.
Disclaimer: The blog articles are intended for educational and informational purposes only. Nothing in the content is designed to be legal or financial advice.