Calculating Real Estate Return on Investment (ROI)

Calculating Real Estate Return on Investment (ROI)

Overview 

Calculating the return on investment (ROI) in real estate is essential for understanding your profits as a percentage of the total investment cost. Two primary methods to determine ROI are the cost method and the out-of-pocket method.

Key Points

• ROI measures the profit from an investment as a percentage of the total cost.
• It compares the invested amount, including purchase price and additional costs, to the current value of the property.
• The cost method and the out-of-pocket method are commonly used to calculate ROI.

Methods to Calculate ROI

Cost Method

• Calculation: ROI is determined by dividing the investment gain by the initial costs.
• Example: If you buy a property for $100,000 and spend $50,000 on improvements, bringing its value to $200,000:
  • Gain: $50,000 (market value increase minus costs)
  • ROI: $50,000 / $150,000 = 33%

Out-of-Pocket Method

• Calculation: ROI is calculated by dividing the equity (current property value minus outstanding loan) by the current market value.
• Example: If you buy the same property with a $20,000 down payment and $50,000 in improvements, financing the rest:
  • Out-of-pocket expense: $70,000
  • Equity: $130,000 (current value minus loan)
  • ROI: $130,000 / $200,000 = 65%

What is a Good ROI?

• A “good” ROI varies by investor and risk tolerance. Higher risk might yield higher ROI, while risk-averse investors may settle for lower returns.
• Typically, investors aim for returns that match or exceed the average stock market returns (e.g., S&P 500, historically around 10%).

Investing in REITs

• Real Estate Investment Trusts (REITs) offer an alternative to physical property investments, providing diversification and trading like stocks.
• REIT returns are generally more volatile than physical properties but offer varying returns (e.g., 3.45% over five years, 6.59% over ten years as of March 2024).

Factors Reducing ROI

• Selling costs, including repairs, advertising, appraisals, agent commissions, and mortgage payoff, can reduce ROI.

Tax Considerations

• Capital Gains: Profits from selling property are taxed as capital gains if held for over a year, or as ordinary income if held for less.
• REIT Income: Income from REITs can be dividends (taxed as ordinary income), capital gains distributions, or returns of capital.
• Rental Income: Must be reported on taxes, with related expenses deductible.

Conclusion 

Calculating ROI helps assess the profitability of real estate investments and compare them with other investment options. For precise calculations and tax considerations, consulting a tax professional is recommended. Download PropertyCard to help with your real estate formulas, calculations and tax filings.