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How to Calculate Return On Investment

I work with many real estate investors and I help people that are new to real estate investing. One of the first things you need to be able to do as a real estate investor is calculate return on investment or ROI.

I will help you understand what return on investment means, how to calculate return on investment and why ROI is important.

If you are working with a great Realtor, then they will be more then capable to calculate return on investment for you. They will also be able to help you to determine how good a potential investment could be.

The purpose of this article is to help you evaluate rental properties, but this formula and information could be used in most any investing opportunity.

Definition

Return on Investment is the measurement of the gain or loss of an investment compared to the initial cost of the investment. This is usually shown as a percentage.

There are a few different ways to calculate return on investment. This is because there are a few different factors involved in the calculations which depend on the situation.

The Formula

ROI = Gross Income – Operating Costs ÷ Cost of Investment

Simple right?

Don’t worry I will explain this.

Return on Investments for Cash Purchases

This is the simplest return on investment calculation with the least number of variables.

The Formula

Annual Net Income ÷ Cost of Investment

Example

  • Purchase Price            $50,000
  • Monthly Rent              $900
  • Monthly Expenses       $160

You will need to first calculate the Annual Gross Income of the property, as an example we can use a monthly rent income of $900.

$900 x 12 (months) = $10,800

Next, you need to add up your Annual Expenses for the property. For our example the owner will pay Taxes, Insurance and Sewer totaling $160 per month.

$160 x 12 (months) = $1,920

Now subtract the Annual Expenses from the Annual Gross Income and this will give you’re your Annual Net Income.

$10,800 -$1,920 = $8,880

Now you will divide the Annual Net Income by the Cost of Investment (Purchase Price).

$8,880 ÷ $50,000 = 0.17 or 17%

A 17% ROI is very good. This would be an investment you should feel confident about.

Now this assumes you are buying a turn key property. If you have to put money into renovations, you will need to add that to the cost of investment. Let’s say you have to put $10,000 into the property your costs would be $60,000 and your ROI will change.

$8,880 ÷ $60,000 = 0.14 or 14%

Return on Investments for Financed Purchases

This calculation won’t be quite as easy, but I will walk you through it and you will be an expert in no time at all.

The Formula

Annual Net Income ÷ Initial Cost of Investment

You will notice a slight difference in this formula. The initial cost of investment will be what you pay for down payment and closing costs when purchasing the property.

Example

  • Purchase Price            $50,000
  • Down Payment           $10,000
  • Closing Costs               $2,250
  • Monthly Rent              $900
  • Monthly Expenses       $160
  • Mortgage Payment     $360

For the mortgage payment I am just using Principal and Interest with a 15 year loan at 7% interest rate. The monthly expenses are the same Sewer, Taxes and Insurance. You may have those added into the mortgage payment, but I like to figure everything up separately.

Annual Gross Income will still be $10,800 ($900 x 12 = $10,800).

Annual Expenses will still be$1,920 ($160 x 12 = $1,920).

Annual Mortgage Payment will be $4,320 ($360 x 12 = $4,320).

Now subtract the Annual Expenses and Annual Mortgage Payment from the Annual Gross Income and this will give you’re your Annual Net Income.

$10,800 – $1,920 – $4,320 = $4,560

Now you will divide the Annual Net Income by the Initial Cost of Investment (Down Payment and Closing Costs).

$4,560 ÷ $12,250 = 0.37 or 37%

Now this assumes you are buying a turn key property. If you have to put money into renovations, you will need to add that to the initial cost of investment. Let’s say you have to put $10,000 into the property your initial costs would be $22,250 and your ROI will change.

$4,560 ÷ $22,250 = 0.20 or 20%

Still a very good investment.

What is a Good Return on Investment?

This is a great question! In my experience the answer will vary by location. In my area a good investment is anything with a ROI above 9%.

I have seen other areas say 8% and some investors don’t want anything under 12%.

It will all determine on your current situation and your long term goals. To help put it all in perspective, if you put your money in bank CD’s you will get around 2-3% which is way less then 9%.

Plus, you actually have to have the cash to put into the CD. With Real Estate Investing you can borrow money to make money.

If you have any questions I would love to talk to you about real estate investing and help you determine your return on investments. Leave me a comment or send me an email.

I also suggest you check out my article “How to Start Investing in Real Estate”. It will help you learn how to finance investments and what kind of deals to look for.

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