The primary reason people invest in the real estate business is to make money. Return on investment is a measurement that enables real estate investors to see the efficiency and profitability of their investment – how much profit they are generating. Therefore, the ROI is vital to determine whether or not an investment opportunity is profitable and worthwhile.
There are three main types of the return on investment, which we’ll go through in this article.
Expected Return on Investment
The first type of return on investment is the amount of profit or loss that a real estate investor anticipates that he/she will make from an investment property that has several known or expected potential outcomes.
Expected return is calculated by multiplying each one of these potential outcomes by the probability of it occurring, and then summing up the results. The trick here is that we don’t actually know the probabilities of each outcome. Therefore, the best we can do is to estimate an expected return, hence the name.
How to Calculate Expected Return on Investment
Let’s take an example. If an investment property has a 50/50 chance of gaining 20% profits and losing 10% of profits, the expected return on investment is:
(50% x 20%) + (50% x -10%) = 5%
This type of return on investment is not only applied to single investment properties, but it can also analyze an entire real estate portfolio containing many investments. To calculate the expected return of an investment portfolio, the real estate investor needs to simply add up the weighted averages of each property’s expected returns. The equation for the expected return on investment of a portfolio with three investment properties is as follows:
Expected return = (weight of property A) x (expected return of property A) + (weight of property B) x (expected return of property B) + (weight of property C) x (expected return of property C)
So, once the expected return of each property is known and its weight has been calculated, an investor simply multiplies the expected return of each property by its weight and sums up the expected return on investment. For example, assume the following portfolio of investment properties:
- Property A with an expected return of 15% and a weight of 50%
- Property B with an expected return of 6% and a weight of 20%
- Property C with an expected return of 9% and a weight of 30%
The expected return of this investment portfolio is:
(50% x 15%) + (20% x 6%) + (30% x 9%) = 7.5% + 1.2% + 2.7% = 11.4%
Keep in mind
Since the market is unpredictable, calculating the expected return on an investment property is more guesswork than definite. Another drawback of this type of return on investment is that it could have been estimated poorly in the first place, which would cause inaccuracy in the calculated expected return of an investment portfolio. Therefore, it is quite unsafe to make investment decisions based solely on the expected return on investment. To learn more about all aspects of real estate investing, continue reading our blog.
Required Rate of Return on Investment
The required rate of return is key for real estate investors to understating and evaluating investment properties before they decide whether or not they should proceed in buying them. It is simply the necessary minimum return needed for the investor to consider a particular investment property. In other words, it refers to how much profit is needed in order to go forward with an investment.
The RRR affects the maximum price real estate investors are willing to pay for an investment property taking into consideration the risk-free rate of return (the theoretical rate of return of an investment with zero risks) and the expected rate of return. If the expected rate of return does not meet or exceed the required rate of return on investment, an investor might not be willing to take on the additional risk.
How to Calculate Required Return on Investment
The required rate of return on investment formula is as follows:
Required rate of return = Risk-Free rate + Risk Coefficient (Expected Return – Risk-Free Rate)
For example, if a real estate investor is considering buying an investment property with an expected rate of return of 10%. Further, assume that the risk-free rate is 3% and the risk coefficient is 0.75. Using the formula above, the required rate of return on this investment would be:
0.03 + 0.75 (0.1 – 0.03) = 0.05 = 5%
Is 5% a good return on investment with regards to the maximum price you’re willing to pay? The required rate of return is different for real estate investors depending on their risk tolerance, real estate investment goals, and other unique factors. So, a 5% RRR might be a risky investment for some real estate investors, and therefore, they might decide to search for a low-risk investment property. Others, on the other hand, might consider this an acceptable return and proceed with buying the investment property.
Actual Return on Investment
The actual return on investment refers to the actual amount of money gained or lost from an investment property during a period of time, in relation to the investment’s initial value. In simpler words, it is what real estate investors actually receive from their investment property.
How to Calculate Actual Return on Investment
The formula for calculating actual return is quite easy:
Actual Return = (Ending Value – Beginning Value)/Beginning Value
For example, assume you’re planning on buying an investment property at an initial price of $100,000 (beginning value) and then selling the investment property, years later, at a price of $120,000 (ending value). In this scenario, the actual return you received equals:
($120,000 – $100,000)/$100,000 = $20,000/$100,000 = 0.2 = 20%
Do not confuse actual return with expected return. On one hand, the expected return is the profit which a real estate investor predicts he/she will gain before even buying an investment property, while, on the other hand, the actual return on investment is the profit which a real estate investor actually makes after buying an investment property and then selling it later on.
The Bottom Line
In conclusion, the return on investment is an important concept in the real estate business. Investors need to be familiar with how to calculate these three types of ROI to make sure they are making the best investment decision before buying an investment property.
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These are three types of rate of return, however, another type that deserves its own blog is “the average rate of return”. Here is everything you need to know about it.