“Hope is not a strategy”
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Calculating Return on Investment
As a real estate investor, you want to make sure that your money is working for you. One metric you’ll need to understand when assessing a potential investment property is your return on investment – or ROI as it’s more commonly referred to. It’s difficult to understate just how important this is. This is the difference between knowing that you’ve made a great financial decision and hoping that your investment will work out. So let’s try and remove that speculation and work with the actual numbers.
Working out the ROI on a property is fairly straightforward – it is expressed as a percentage, and is calculated using the following formula:
(Total Cashflow – Expenses) ÷ Cost of the Property
The best way to learn is by looking at an example:
Purchase Price: $250,000
Monthly Rent: $1,500
Expenses: $500
Monthly Cashflow: $1,000
Let’s say we had the situation above. We purchased a house for $250k, we’re able to rent it out for $1,500 per month, and we have $500 worth of expenses (not including debt service payments) per month. This means that our total cashflow is $1,000 per month ($1,500 – $500).
We’ll be covering expenses that you should budget for in a future article, but for now, let’s just assume that they are a fixed amount per month and lump them together into one $500 payment.
Now, we multiply monthly cashflow by 12 to give us the yearly cashflow of $12,000. This number is divided by the purchase price of $250k, and that gives us our ROI.
What Does Return On Investment Tell Us?
Understanding the return on investment of a particular property gives us some very useful information. For starters, it tells us how much profit or loss that single investment has earned relative to the amount that was paid for it. More importantly, given that it’s a ratio – we’re able to compare the ROI of one or more properties in order to make investment decisions. If one property has a better ROI than another, all else being equal, that property is generally the better investment. You can use this to make an educated decision as to which investments you want to make.
In real life, we seldom get the opportunity to compare two identical properties and only look at the ROI. There are all sorts of other factors like how much maintenance a property needs, details of the property (size, amenities, etc), what neighborhood they are located in, etc. However, the point to this article was to simply illustrate what ROI is and how to calculate it.
We also get to know that in order for this investment to pay us back the entire amount, we’ll have to wait 20.83 years. To find this number, just divide 100% by 4.8%. This assumes that the rent and expenses remain the same for the whole time, which of course they will not. We all feel the effects of inflation, and that will impact both the rent and expenses over time.
What About the Mortgage?
We know what you’re thinking… they didn’t even include the mortgage in that calculation? And you’d be correct. We left this out for a reason. Debt, when used responsibly can be an incredible tool. It can drastically change the ROI on a property. How you utilize this is up to you, but we’ll run through a few examples in the next article so you can make the investment decisions that are right for you.