What Is Real Estate Return On Investment (ROI)?


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Real estate investors look at all types of properties. Some focus on commercial real estate like shopping centers or office buildings, while others may be more interested in apartment buildings or single-family homes. Many investors seek the income stream from rental properties, while some may be more interested in flipping properties to profit from appreciation.

In every type of real estate investment, it’s important to consider return on investment (ROI) when making an investment decision.

What Is ROI?

ROI is a metric that investors in any asset class can use to evaluate and compare investment performance. It’s a percentage that shows how your net profit from an asset measures up against what it cost you.

There are two primary ways to make money in real estate, through appreciation or rental revenue.

When it comes to real estate appreciation, ROI is determined when a property is sold. It’s the profit remaining after deducting the property’s purchase price plus any costs for renovations or repairs.

If you buy a property for $300,000 and sell it for $375,000 several years later, that’s $75,000 in appreciation.

However, if you spent $20,000 on renovations, your total cost for the property would be $320,000. If you subtract the total cost of $320,000 from the sale price of $375,000, you have a profit of $55,000. Divide that profit of $55,000 by $320,000 and your ROI is 17%.

How to Calculate ROI

The basic ROI calculation is:

(Sale Price of Investment – Cost of Investment)/Cost of Investment

Unlevered and levered cash sales. This is the most straightforward calculation. If you’re selling a property that you bought outright for cash, just subtract the total investment cost, including any renovations or repairs, from the sale price and divide by the cost to get the ROI. If the property purchase was financed (leveraged), add the interest cost to the total investment cost as well.

Rentals. Many investors purchase rental properties to benefit from the long-term income stream. To calculate the ROI for a rental property, first estimate the annual rental income and annual operating expenses, which would include the costs of maintenance, property taxes, utilities and other ongoing costs. Most rental properties are financed. Assuming this, the ROI is calculated by subtracting annual rental income from annual operating costs and dividing by the balance on the mortgage loan.

REITs. A real estate investment trust (REIT) is a pooled investment in properties. Investors can buy shares in a REIT, just as they would buy shares in a mutual fund, and earn dividends based on the income generated by the properties held in the REIT. Investors may also sell their shares in a REIT to benefit from appreciation. In fact, many REITs are publicly traded, and shares are bought and sold just like stocks. As with stocks, the ROI is simply your net gain from a REIT investment divided by your cost.

What Factors Impact the ROI on Real Estate?

A variety of factors can impact the potential return on real estate investments. Not surprisingly, market conditions have the greatest influence.

Supply and demand determine market dynamics. When supply is tight and there are fewer properties on the market, prices rise, and sellers enjoy higher returns on investment.

Purchase Price

Purchase price obviously has a significant impact on ROI. If you pay more for an investment and/or spend a significant amount on renovations, you’ll reduce your return unless the property value appreciates.

Interest Rates

Interest rates have a very strong impact on real estate investment returns. When the Federal Reserve raises interest rates, mortgage rates often increase and depress the real estate market since demand falls as buyers retreat, awaiting a better interest rate environment. If you sell in such a market, the selling price will be lower, and the profit will be reduced.

Location

A property’s location is relevant, whether it be a commercial or residential property. For example, a highly trafficked area is desirable for a shopping center and should increase the property’s value. A single-family home in a safe neighborhood with good schools is more valuable than an identical home in an undesirable area and will sell at a higher price.

Demographics

Demographics are a factor. Peter Michaelis, a real estate agent with Ginnel Real Estate in Bedford, New York, says, “Population demographics can have a significant impact on supply and demand. As a result of the Covid-19 pandemic, when employees were unable to be in the office every day, we’ve seen a lot of younger families and people moving out of the city. This has led to an extremely dynamic real estate market.”

Materials

The cost of construction materials will affect ROI, as renovations become more expensive. Rising prices for stone, gravel, lumber, and fixtures will all reduce profits, as will higher labor costs.

Type of Property

The type of property can impact profitability. According to Vital Aelion, chief investment officer with Denver-based Ironton Capital, “Affluent properties are typically less attractive investments than cheaper homes, as they generate lower rental returns. For example, in the Denver area, a $200,000 property generates a rent of around $2,000 per month. A $1 million property will rent for approximately $4,000 per month.”

Strategy

Your real estate investment strategy is relevant. Each type of strategy has a specific return structure, and returns will vary accordingly. Popular strategies include, buy-and-hold, flipping, renting properties and investing in REITs or private real estate funds.

Average ROI in the U.S. Real Estate Market

In the U.S. market, the median return on real estate is 8.6% annually according to the S&P 500. Investment strategies affect the return on investment, and different types of properties attract investors employing different strategies. Residential properties generate an average annual return of 10.6%, while commercial properties average 9.5% and REITs 11.8%.

Investors typically analyze data pertaining to specific geographic regions or metropolitan areas to compare returns and the cost of capital to inform their investment decisions.

Additional Profitability Metrics

While ROI is the most significant metric to assess profitability, investors use other metrics to ensure they have a comprehensive picture of overall returns.

  • Capitalization rate. The cap rate is a measure of the annual, debt-free rate of return on a rental property. It’s calculated using net operating income, property value and rate of return. The cap rate varies among markets, and real estate investors use this metric in their analysis of investment opportunities.
  • Internal rate of return. IRR is a more complicated metric that compares the future value of an investment with its value in current dollars (the net present value, or NPV).
  • Cash-on-cash return. This metric is typically used for a one-year period and compares pretax cash flow from a real estate investment to the total cash invested.

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