ROI (Return on Investment) is a tool that helps investors decide if an investment will be worth their time, money, and energy. And a quick ROI calculation can help you make smart investment decisions.
In this article, we’re going to explain how to calculate ROI on real estate investments and how to tell if you’ve found a good investment.
But we should start by answering a more basic question: How is ROI in real estate defined?
What is ROI in Real Estate?
ROI in real estate is a calculation that measures the profitability of an investment, compared to the cost of the investment. By calculating the ROI, you can determine if a property is a good deal. You can also compare ROIs for multiple properties to decide which property represents the better investment opportunity.
How Is ROI on Real Estate Calculated?
In general terms, ROI in real estate can be calculated in one of two ways:
- The Cost Method, which compares gains to costs (typically used when no financing is involved), and
- The Out-of-Pocket Method, which compares equity to market value (typically used when financing is involved).
The Cost Method
The cost method is the most basic formula for calculating ROI, and it works as follows:
Investment Gains / Investment Cost = ROI
To use this formula, you would first find your gains by subtracting the cost of your investment from the total value of the investment. Then you would divide that amount by your investment costs. This tells you how your gains compare to your costs.
In many cases, you need to work with projected figures. Projected figures are estimates based on similar projects that have been completed in your market recently. For example, you might need to get renovation estimates from a local contractor and discuss the after-repair value (ARV) with a real estate agent to project a sales price.
Here is an example:
Let’s say you expect to spend $500,000 to purchase and renovate a home. And you expect this home to sell for $600,000 once the renovation is complete. You would take your gains of $100,000 divided by your costs of $500,000 to arrive at .2. This means your projected ROI on this project would be 20%.
The Out-of-Pocket Method
When you leverage debt financing and compare equity to market value, your ROI is higher. The Out-of-Pocket Method is used for this ROI calculation, and the formula looks like this:
Equity / Market Value = ROI
Here is an example:
Let’s say you expect to spend $500,000 to purchase and renovate a home. And you expect this home to sell for $600,000 once the renovation is complete. But, rather than pay (paying?) all cash as we did in our first example, you spend $100,000 in renovations plus $80,000 for a 20% down payment. The rest of the deal is financed with a mortgage loan.
In this case, your out-of-pocket expense is $180,000. And, if the property can be sold for $600,000, your equity position is $420,000. By dividing the $420,000 equity by the $600,000 market value, you get .7. This makes your projected ROI on this project 70%.
Calculating ROI on Different Real Estate Investment Types
While the cost method and out-of-pocket method are the two basic means of calculating ROI, it’s important to note that there are even more ways to calculate the ROI on real estate investments. This is because different investment types have different financial objectives. In a fix-and-flip, for example, you’re most concerned with how much you can sell the property for once the renovation is complete. But with a long-term rental, you’re more concerned with incoming rents than resale value.
So let’s consider different investment types and explain how to properly calculate the ROI for each.
Fix-and-flips can be one of the best short-term investments in real estate. By purchasing an affordable property and adding value through renovation, you can sell for much more than the sum of your costs.
Both the cost method and out-of-pocket method can be directly applied to fix-and-flips. In fact, our examples above are both representative of fix-and-flips. But let’s look at one more example to see how much you could make flipping a house. We’ll use the cost method, but we’ll include a few more expenses that better reflect real-world conditions.
Let’s say you project the following costs:
● Purchase price: $400,000
● Closing costs on the purchase: $20,000
● Renovations: $100,000
● Closing costs on the sale: $30,000
And you’re expecting to sell for $600,000 after repairs.
In this example, your total cost is $550,000. Subtracting this from the $600,000 ARV, you have a gain of $50,000. Dividing this gain by your $550,000 cost gives you .09. So your ROI would be 9%.
Rental properties are the cornerstone of building a real estate portfolio. Rentals give you the greatest tax benefits of real estate investing, plus monthly rental income and long-term appreciation. But because you’re holding the property and earning passive income each month, the ROI models that we’ve looked at so far don’t really apply.
So to calculate the ROI on a rental property, we’re going to use a different formula:
(Annual Rental Income - Annual Operating Costs) / Mortgage Loan Balance
This will tell us how our net operating income (NOI) compares to the balance still to be paid on the loan.
Here’s an example.
Let’s say you take out a loan of $400,000 to buy a second home as a rental property. A few years into your investment, you’re receiving $4,000 per month in rent ($48,000 per year), and you have monthly expenses of $400 ($4,800 per year) for things like property taxes, insurance, and maintenance. You’ve also paid down a bit of your mortgage balance, so your current balance is $375,000.
In this case, you would subtract your annual operating costs of $4,800 from your annual cash flow of $48,000 to get an NOI of $43,200. Then you would divide this by the current loan balance of $375,000 to get .1152. This means your ROI would be 11.52%.
What is a REIT? A REIT (Real Estate Investment Trust) is a company that invests in income-producing real estate. Investors can buy shares in a REIT on the stock market and earn dividends on those shares. So instead of owning investment properties directly, REIT investors own shares of a company that owns investment properties.
REITs publish their calculated ROIs, saving you the trouble of doing the calculation yourself. The nice thing about these REIT ROIs is that you can compare them to your ROIs for other real estate investments to decide if your money would be better off in a REIT or a physical property of your own.
What is an Average ROI in Real Estate?
As we’ve seen, different ROI methods return different results. So it’s important to make sure you’re comparing apples to apples when you compare ROIs. In most cases, the cost method will be more comparable to other methods than the out-of-pocket method.
It’s also important to note that short-term returns can be higher or lower than long-term averages, depending on market conditions. The average ROI in real estate for 2020, for example, is likely higher than the average ROI over the last 10-year period because real estate was in high demand and short supply in 2020.
According to Bankrate, the average return on investment in the US for 2021 was 10.6% for residential real estate. Commercial real estate averages around 9.5%, and REITs average around 11.8%.
What is a Good ROI in Real Estate?
Your ROI could outperform averages if market conditions are particularly strong and/or if you have a unique investment strategy.
The housing boom of the pandemic era is a good example of market conditions leading to better-than-average ROIs. In most years, 7-10% is considered a good ROI in real estate, but because property values and rental rates were growing rapidly, the entire real estate market saw higher ROIs than normal.
The unique investment model from Gatsby Investment is an example of using strategy to achieve good ROIs. Gatsby Investment is a real estate syndication firm that pools money from multiple investors to fund high-yield real estate projects with low minimum investments. For 2021, Gatsby averaged a return of 26.5% for investors! You can view the performance of each project to see how the returns for different investment types compare.
Other Ways to Calculate Real Estate Profitability
As we’ve mentioned, different investment types offer different financial benefits, so it makes sense to have multipleways to measure the profitability of a real estate project. Here are a few of the other ROI methods you might see in the real estate industry.
The formula for calculating a cap rate in real estate is very similar to the formula we used above to calculate rental property returns. The only difference is that a cap rate (short for capitalization rate) formula uses the market value of the property rather than the mortgage balance. Cap rates are used as a metric for determining the risk and reward of many income-producing commercial properties (including multi-family residential properties with more than four units). While real estate is generally considered a low-risk investment, some investors prefer to seek out higher-risk investments for higher return potential, and this cap rate formula indicates the return potential for investments.
IRR (Internal Rate of Return) compares the future value of a real estate investment using the value of a dollar in today’s economy. ROI doesn’t account for the time value of money (meaning that ROI ignores the impact of inflation on the value of a dollar. But IRR does factor in the time value of money. The formula goes beyond basic math functions to find the net present value (NPV), so most investors use a financial calculator rather than working with the manual formula.
Cash-on-cash returns compare your pre-tax income from rental properties with the total amount of cash you have invested in the property. Simply divide your annual rental income by the cash you have invested in the property. This tells you how much of your investment you’re making back each year.
Gatsby Investment’s ROI
If you’re looking to achieve strong ROIs on your real estate investments, consider investing with Gatsby Investment. With average annualized returns of 26.5% for 2021, and a strong track record of financially successful projects since 2016, Gatsby has earned the trust of real estate investors all over the world!