If you’ve ever considered investing in real estate – or if you’re just an avid fan of popular house flipping shows – you’ve probably heard the term ROI. For both experienced and first-time investors, ROI is a powerful tool that can be used to increase the chance of a profitable investment. But what exactly is ROI, and how do you calculate it? In this article, we’ll explore everything you need to know before you make an offer on that fixer-upper.
What Is ROI In Real Estate Investing?
Return on investment (ROI) is a metric that helps real estate investors evaluate whether they should buy an investment property and compare, apples to apples, one investment to another. ROI allows investors to predict, based on comparables, the profit margin they should realize on their real estate – either through flipping homes or renting properties – as a percentage of cost.
When it comes to real estate investments, ROI is an important tool for any investor regardless of their experience level as it provides a concrete, factual look at how profitable a potential investment might be.
How Is ROI Calculated For Real Estate Investments?
Although it may sound complicated, most ROI calculations are actually very simple. In general, the ROI of an investment is equal to the gain minus the cost, divided by the cost.
ROI = (Investment Gain − Investment Cost) ÷ Investment Cost
But some calculations may vary depending on the type of investment being considered. Variables such as repair and maintenance costs, the initial amount of money borrowed to make the investment and certain mortgage terms will ultimately impact the ROI. To help you ensure your investment is secure, we will be breaking down some of the most common scenarios in which ROI is used and how you can account for these variables in your calculations.
Resales And Cash Sales
For the simplest ROI calculation, it’s easiest to assume a cash deal and a resale, also known as a flipped property investment. In this scenario, the investor doesn't have a mortgage to account for in their calculations.
For example, suppose an investor buys a long-vacant foreclosure house for $100,000 and knows that comparable homes in good repair can sell for $200,000. They then spend $50,000 to renovate, planning to put it on the market for $200,000 when the repairs are completed. In this scenario, the ROI is 33.3% using the following equation.
ROI = Net Profit ($200,000 − $150,000) ÷ Total Investment ($150,000)
If you’re looking to earn rental income through your investment property, there will be a few additional steps to determine the property’s ROI. This starts with estimating your annual rental income, which is frequently accomplished by searching for similar rental properties in the area. During this step, look for the average monthly rent for the type of property and multiply that rent by 12 to determine the potential annual rental income.
Once you know the annual potential rental income, you can use it to estimate your net operating income. The net operating income of a rental property is equal to the annual rental income minus the annual operating expenses – such as maintenance, insurance, property taxes and homeowners association (HOA) fees. When calculating your net operating income, be sure not to include your mortgage payments or interest, as these will be accounted for elsewhere in the ROI calculation.
Now that you’ve subtracted your operating costs from your potential rental income, you have your potential net operating income and you’re ready to calculate the ROI. Divide your net operating income by the total value that's still due on the mortgage to determine the ROI. The formula will look something like this:
ROI = (Annual Rental Income − Annual Operating Costs) ÷ Mortgage Value
If you’re looking for more passive investments, buying shares in real estate investment trusts (REITs) may allow you to enjoy the returns without doing any of the work. REITs or REIT funds are bought and sold on major public exchanges and offer steady income and appreciation growth, with an average annual return of 12.99%.
How Do I Calculate ROI Under Variable Circumstances?
Several variables, such as changing mortgage payments on an adjustable-rate mortgage, may make ROI calculations significantly more complex. For those calculations, you’ll need computer software or a financial calculator to ensure you have the information you need to evaluate the investment.
What Is An Average ROI On Real Estate?
With so many variables to consider, there’s no single overall average ROI in real estate. It’s important to note that this average would depend on what part of the real estate market is being discussed – so while metrics are useful for predicting results, they are by no means a guarantee.
Ultimately, ROI depends on the amount of risk that’s inherent in an investment, and some risks – like the pandemic and its effects on the commercial real estate market – simply cannot be anticipated. Although these varying factors mean there’s no average to base your investment on, most investors aim for returns that match or exceed 10%.
Are There Other Ways To Measure Investment Profitability?
ROI is just one of several measurements that real estate investors use to evaluate investment opportunities. Other metrics include the capitalization rate, internal rate of return (IRR) and cash-on-cash returns, and ideally, several of these metrics should be used together to evaluate a property.
How Many Mortgages Can I Get To Buy Investment Properties?
What’s the first thing you should do when you know you’re ready to buy that first property? Get preapproved for a mortgage. It’s your proof that you have the money to do the deal, and you’ll need it to be taken seriously by agents and sellers. Take a minute to familiarize yourself with the regulations around the mortgage industry and the limits on borrowing for investment properties.
The Regulatory Framework
The mortgage industry is regulated by the federal government, which buys mortgages that conform to its rules from lenders after origination through Fannie Mae and Freddie Mac. These government-sponsored enterprises follow rules set by the Federal Housing Finance Agency, which also govern mortgages backed by the Federal Housing Administration (FHA), the Veterans Administration (VA) and the U.S. Department of Agriculture (USDA).
The Limits On Borrowing
Many people think it’s hard to get financing for investment properties, but what they may not know is that investors can get up to 10 conforming mortgages without paying commercial mortgage rates.
Each mortgage can be used to purchase a single family property, which according to the FHFA, includes multiunit properties up to four units. That means you could own as many as 40 investment units before graduating into the world of commercial real estate financing.