How Is ROI Calculated For Real Estate Investments?
Although it may sound complicated, most ROI calculations are relatively simple. In general, the ROI of an investment is equal to the gain minus the cost, divided by the cost.
ROI = (Investment Gain − Investment Cost) ÷ Investment Cost
Some calculations may vary depending on the type of investment being considered. Variables such as repair and maintenance costs, the initial amount of money borrowed to make the investment, and certain mortgage terms will impact the ROI.
Several factors, like changing mortgage payments on an adjustable-rate mortgage, may make ROI calculations significantly more complex. For those calculations, you’ll need computer software or a financial calculator to ensure you have the information you need to evaluate the investment.
To help you ensure your investment is solid, we’ll break down some of the most common scenarios in which ROI is used and how you can account for these variables in your calculations.
Resales And Cash Sales
For the simplest ROI calculation, it’s easiest to assume a cash deal and a resale, also known as a flipped property investment. In this scenario, the investor doesn't have a mortgage to account for in their calculations.
For example, suppose an investor buys a long-vacant foreclosure house for $100,000 and knows that comparable homes in good repair can sell for $200,000. They then spend $50,000 to renovate, planning to put it on the market for $200,000 when the repairs are completed. In this scenario, the ROI is 33.3% using the following equation.
ROI = Net Profit ($200,000 − $150,000) ÷ Total Investment ($150,000) = .33
Rental Properties
If you’re looking to earn rental income through your investment property, there will be a few additional steps to determine the property’s ROI. This starts with estimating your annual rental income, which is frequently accomplished by searching for similar rental properties in the area. During this step, look for the average monthly rent for the type of property and multiply that rent by 12 to determine the potential annual rental income.
Once you know the annual potential rental income, you can use it to estimate your net operating income. The net operating income of a rental property is equal to the annual rental income minus the annual operating expenses – such as maintenance, insurance, property taxes and homeowners association (HOA) fees. When calculating your net operating income, be sure not to include your mortgage payments or interest, as these will be accounted for elsewhere in the ROI calculation.
Now that you’ve subtracted your operating costs from your potential rental income, you have your potential net operating income and you’re ready to calculate the ROI. Divide your net operating income by the total value that's still due on the mortgage to determine the ROI. The formula will look something like this:
ROI = (Annual Rental Income − Annual Operating Costs) ÷ Mortgage Value
REITs
If you’re looking for more passive investments, buying shares in real estate investment trusts (REITs) may allow you to enjoy the returns without doing any of the work. REITs or REIT funds are often bought and sold on major public exchanges and can offer steady income and appreciation.
