There are many real estate metrics used by investors in order to choose, analyze, and manage the best real estate investments. Some of the most popular and widely used ones are the cap rate and the cash on cash return. Today, however, we will review another real estate metric which is used for broader analysis but is extremely useful if you want to make money with real estate investments. This is, namely, the rate of return on investment. We will discuss what the rate of return on investment is in real estate, how to calculate rate of return on investment, and why real estate investors need to use it.
What Is the Rate of Return on Investment?
The rate of return on investment is, simply, the gain or loss a real estate property generates minus its initial costs over a specific period of time. The value is typically expressed as an annual percentage rate. Rate of return on investment can be computed through the cash flow of the real estate property.
The Gains of an Investment Property
When we are talking about the gains a real estate property generates, we are talking about profit. Real estate investors compute the gains by summing the income and any other capital gains associated with the investment property. The latter might be a result of the sale of the real estate property, for instance. To generate a gain, the selling price of the property should exceed the initial purchase price of the real estate investment. The principle here can be associated with the positive cash flow of an investment property: the money that inflow (the selling price) is higher than the money that outflow (the initial purchase price). Let’s review an example from residential real estate investing in order to make this explanation clearer:
Imagine that Frank has a business career in residential real estate investing, and he prefers to invest in short-term rather than long-term investment properties. Frank buys an apartment for $100,000. He leases the investment property for one year with monthly rent of $500. After the year has passed, Frank decides to expand his residential real estate investing business by selling this apartment and buying a house instead. He manages to sell the property at a higher price: $130,000.
In this case the received income is $130,000, and the additional capital gains are the collected monthly rents 12 x $500. Last but not least, the initial investment is $100,000. These are all the values real estate investors need to compute the rate of return on investment. Before reveling the formula, nevertheless, it is necessary to explore the second possible scenario of real estate investing.
The Loss an Investment Property Generates
Every realtor wants to find the best real estate investments which generate positive cash flow, be successful, and make money with real estate investing. However, this is not always the case. Sometimes long-term investment properties generate less income than their costs. Moreover, it occasionally happens so that the real estate investor sells the property at lower price than the initial purchase price. In such cases, the value of the rate of return on investment is negative. Therefore, we speak about the loss the real estate investment has generated. Due to this reason, many real estate investors conduct various analyses such as calculating the cash on cash return and the cap rate as well as the rate of return on investment before buying a property.
How to Calculate Rate of Return on Investment?
At this point you are probably asking yourself: “How to calculate rate of return on investment?“. The formula is pretty simple:
Rate of Return on Investment = (Final Investment Property Value – Initial Investment Property Value)/Initial Investment Property Value
Let’s review the Frank example. The final investment property value in this case would be the received income ($130,000) plus the additional capital gains (12 x $500). Therefore, the final investment property value is $136,000. The initial investment property value is $100,000. Thus, the calculation goes as follows:
Rate of Return on Investment = ($136,000 – $100 000)/$100,000
Rate of Return on Investment = 36%
So what? How to use rate of return on investment in order to make money with real estate investing and find the best real estate investments? Here are some of the benefits of using this real estate metric.
Why Is the Rate of Return on Investment Useful?
- Rate of return on investment is used to compare different real estate properties. In this way, every realtor can easily find the best real estate deal for his/her businesses. Due to the fact that this real estate metric is easy to compute, it gives quick results. Moreover, it provides the investor with a broader view of the real estate asset.
- Real estate investors can use the formula for calculating rate of return on investment in many beneficial ways. For instance, if an investor knows what interest he/she wants to make with an investment property and the potential sum of selling it, he/she can easily calculate what maximum amount he/she could spend for buying the investment.
Limitations of the Rate of Return on Investment
As every other real estate metric, rate of return on investment has its limitations. There is one main disadvantage of rate of return on investment. This is the fact that is does not take into consideration the inflation rate. However, another metric, called real rate of return on investment, represents the annual return in percentage, but already adjusted to taxes, the inflation rate, and other external factors. The real rate of return on investment is simply subtracting the inflation rate from the rate of return on investment.
If you are willing to learn more about other real estate metrics such as cash on cash return, cap rate, and internal rate of return as well as many other useful real estate tips, keep reading on Mashvisor.