Why is it important to know ROI in real estate?12 min read
You invest to earn profits but investing in real estate can be tricky. Imagine if you could have an estimate of the profits that you could make before investing itself?
Would that not help you make a smarter choice? Yes, it will and thus, help in increasing the ROI in real estate.
Making the right decision is the key to real estate. It is challenging but not unrealistic.
ROI or return on investment is a key metric that could help you out when assessing the performance of assets before really investing.
For example, this metric could help you decide between two assets based on the efficiency quotient to not lose money.
Understanding ROI In Real Estate
What is ROI? Simply put, it is the ratio of the profits earned with respect to the cost. Therefore, the cost is calculated as a percentage of the profits based on what you earn.
This metric can be used for any investment, be it stocks, bonds, or even real estate. However, several variables such as mortgage costs, repair, and maintenance costs are needed to get the exact ROI.
Why is ROI analysis important in real estate?
Knowledge arms you with power like nothing else, and the same goes for ROI in real estate as well. Knowing ROI makes you an informed investor.
And a well-read and well-researched investor, by calculating the ROI, can filter and narrow down the kind of assets to invest in so that he can know how much he will make.
If at any juncture an investor feels that the cost and expenses are more than the ROI, he can easily decide to exit a deal or sell it off so that he does not lose out on money.
The higher the ROI, the greater are the returns. And so, you must prioritize and focus on assets with higher values to maximize your profits.
That is why ROI is such an important metric to consider when investing in real estate. But how do we calculate ROI? First, let us look at the mathematical way.
How to calculate ROI In Real Estate?
ROI = Profit after deducting the cost X 100
Simple! The equation looks easy. But things are not that simple; several variables affect ROI. And this gives birth to different calculation methods.
Different methods of ROI calculation
1) Cost method: This method is for properties bought totally with cash. It is probably the simplest method of calculating the ROI as there are no mortgage and monthly interests involved in this transaction.
ROI = Net operating income X 100
What does the net operating income here refer to? It is the total income generated from a property. It is otherwise calculated as the difference between the income generated and the expenses.
2) Out-of-pocket method: This method works for investors who buy properties on mortgaged financed transactions. Now, this method gives higher ROIs and, as a result, is popularly used.
It is a more involved process, and you need to factor in a lot more things to calculate, but to simplify, here’s a calculation method.
ROI = Value of Property – Downpayment X 100
Value of Property
Complications in calculating ROI In Real Estate
A significant factor affecting the total cost of investment is the financing terms when buying a property. However, complications in the ROI calculations occur when a property or an asset is either refinanced or mortgaged for a second time.
How? Well, that’s because interest or the loan fees on a second loan or a refinanced loan may bring down your ROI.
An increase in maintenance costs, property taxes, and utility rates, too, are significant factors that should be considered. ROI should be calculated by bringing in these numbers.
Property purchased with an adjustable-rate mortgage (A loan that doesn’t have a fixed rate of interest. The rate keeps changing based on market conditions periodically.) too can put forward a complicated calculation. Nevertheless, there are tools that you can bank on by factoring in all these numbers so that your ROI figure is clear.
Metrics to consider when calculating ROI in real estate
While there are many metrics to consider when purchasing a property, there are four main metrics for calculating ROI in real estate. So, let’s look at them.
Here you go:
1) Capitalization Rate: Also popularly called the cap rate, this particular metric stands for the value of the property that you intend to buy for the income it produces. So, basically, it is the ratio of the net operating income (NOI) to the asset value of the property.
Cap rate: NOI/Market Value
The NOI or the net operating income, or the gross operating income, is calculated by reducing the operating expenses from the total.
The higher the cap rate, the higher the returns, and that would also mean higher risks. A positive cap rate would be different for different properties.
It would be affected by factors like location, interest rates, and even the type of property. You can use this cap rate to compare the properties.
2) Cash on Cash Return: A vital metric to consider when analyzing ROI is cash on cash return which is calculated as:
Annual Income from the property/Total Investment.
3) Price to rent ratio: This particular metric can be calculated to find out whether you should buy or rent a property in a specific area.
4) Gross rent multiplier: Similar to the cap rate, this metric, too, evaluates the profit and value of a property. The difference, however, lies in the term gross. GRM is the number of years a property would take to make profits with the gross received rent.
GRM or gross rent multiplier is calculated like this:
GRM = Market Value/Gross Rental Income
What’s a good ROI in real estate?
Now, that we know how to calculate the ROI, the complications, and the metrics to consider, it is but natural that we should also know what good ROI means.
A good ROI cannot be the same for everyone. What may be suitable for one may not be for the other. If you expect a higher ROI, then increase the level of your risk tolerance.
Conversely, investors hoping for certainty and not keen on risks should be prepared to settle for lower ROIs.
An informed and calculated investor will never be let down; remember that. However, if you are a novice and need advice on how to go about investing, there are numerous platforms to help you analyze and assess the performance of a property.
Don’t hesitate to take help and make an informed decision. Join the dots well, count the metrics and factors and then dive in.
Do your math well, and happy investing!