For real estate investors, calculating the return on investment properties is an important step to do. You wouldn’t put your money on a long-term deposit at the bank without knowing what return they will pay you. Investing in a real estate property should be no different. Knowing your investment returns will make you a smarter real estate investor.
But how do you calculate the ROI of an investment property? Here are 8 steps to follow:
Calculating the Rate of Return Step 1: Calculate How Much Cash You’re Putting into the Deal
Before calculating how much you are going to make from your investment property, first you need to calculate exactly how much cash you are putting into your investment property. In addition to your deposit, you also need to take into account other expenses such as bank fees, solicitor fees, out of pocket money, and any cash you put to buy an investment property and get it to generate income.
This figure is important because you need to know exactly what return you are getting on the money you actually invested. If you’re making $10,000 from an investment property in which you put $50,000 of your own cash, then you are not getting a very good return. However, if you put just $1,000 into that investment, then you’re getting huge investment returns.
- Let’s take an example to follow throughout this entire blog to make things easier and more comprehensive, and say you put in a total of $30,000 to purchase a $250,000 property.
Calculating the Rate of Return Step 2: Calculate Your Expected Investment Income
The second step you need to do is calculating your expected investment income. This is a simple sum; all you need to do is assess how much rent you expect to collect per week/month. Thus, simply multiply your expected weekly income by 52 to get this figure.
- For our example, suppose you were renting your investment property for $350 per week, this makes your yearly investment income $350 x 52 = $18,200.
Calculating the Rate of Return Step 3: Calculate Your Expected Expenses
Now, you need to calculate your annual expenses on the property. This step can be complicated because you need to take into account everything that you will have to pay money for, such as:
1. Management fees – If you choose to have a real estate agency manage the property instead of managing it on your own.
2. Mortgage repayments – If you decide to buy an investment property with a mortgage, not fully in cash.
3. Utilities – Including water, electricity, and gas. However, in most cases the tenant will pay these fees, thus only put these down if you have to pay them yourself.
4. Council rates – They pay for things like garbage collection and maintaining the local area.
5. Maintenance of the property
8. Legal fees – If you needed legal advice.
9. Accountant Fees – If you hired an accountant to do your tax return.
- Continuing with our example, let’s simply say that the total of all of your expenses adds up to $15,500.
Calculating the Rate of Return Step 4: Subtract the Cash Flow from Your Expenses (Surplus)
This step is very straightforward; all you have to do is to take your total expected income and subtract the total sum of all of your expenses.
- To continue with our example, you would take the entire expected income from step 2, and subtract the total expected expenses from step 3 ($18,200 – $15,500 = $2,700).
Calculating the Rate of Return Step 5: Divide Your Excess Cash by Your Investment Capital
For this step, you have to take the surplus (the figure you just worked out above), and divide it by the total amount of money you initially invested in the real estate property.
- The surplus is $2,700, so we would divide that by the $30,000 we initially put into the investment property: $2,700/$30,000 = 9%. This is known as the cash on cash return.
So, in this example, the real estate investor is getting a 9% rate of return on his/her money before taking into account the capital gains. So now, for our next steps, the capital gains are taken into consideration.
Calculating the Rate of Return Step 6: Calculate Your Expected Capital Gains Growth
To accurately calculate ROI on an investment property, real estate investors need to take into account the capital gains growth they are expecting from the property. Capital gains are hard to predict because they are largely driven by the market which can be unpredictable.
- For our example, let’s say the real estate investor is expecting a 5% growth in his/her capital gain from the $250,000 purchased property. In this case, the growth in the first year would be $250,000 x 0.05 =$12,500.
Furthermore, you need to bear in mind that each year the real estate investor’s amount of capital gains growth changes as the real estate investment property goes up in value.
- So, to continue with our example, in the first year our the property’s worth was $250,000 and went up in value by $12,500. In the second year, our property’s worth is now $262,500, and if we get the same 5% growth, our property will go up in value $13,125 ($262,500 x 0.05), and so on.
Calculating the Rate of Return Step 7: Add the Capital Gains from Your Surplus Previously
For this step, real estate investors need to take the expected capital gains growth and add it to their cash flow surplus from step 4.
- The real estate investor’s capital gains growth was $12,500, and the surplus was $2,700. Add these together, and you get $15,200.
Calculating the Rate of Return Step 8: Divide All This by Your Investment Capital to Get Your ROI
This is the exciting step because you will finally get to see your investment returns. The last step for calculating the rate of return is easy; real estate investors simply take the total from step 7 and divide it by the initial capital investment.
- The real estate investor’s dollar return in our example was $15,200 after including capital gains and cash surplus. Now, let’s take this figure and divide it by the initial investment of $30,000. This gives us a massive return of 50.67%.
Before concluding, it needs to be mentioned that for calculating the rate of return on investment in our example, we have not taken into account the expense of paying tax. When you sell a real estate investment property and access your capital gains, you’ll have to pay tax on that growth in addition to paying tax on your annual cash flow surplus. Depreciation and taxation benefits – which could increase your annual surplus – were also not taken into consideration for calculating the rate of return in our example.
Looking for an Easier Way for Calculating the Rate of Return on Investment?
In this blog, we walked you through the 8 steps for calculating the rate of return on investment properties, but if you want an easier way to do this, then you are in luck.
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One concept that you probably noticed was not mentioned here is the internal rate of return calculation (IRR). This is because we’ve designed a separate blog to introduce you to the different approaches to calculating the internal rate of return with specific examples. Click here to learn all about them.