All You Need to Know about Return on Investment (ROI) in Real Estate 2024

Talia Lee-
June 25, 2024

When evaluating a real estate purchase for investment purposes, understanding the potential return on investment (ROI) is crucial. ROI measures the profitability of an investment relative to the amount spent. Here’s a guide on how to assess ROI and the factors influencing the profitability of your investment:

ROI, or return on investment, in real estate refers to the profit realized from a property purchase after deducting all associated costs, such as the purchase price, repairs, and other expenses. This return is earned over the ownership period through rental income and upon sale through capital gains or losses.

“ROI measures the earnings relative to the investment made,” explains Greg McBride, chief financial analyst at Bankrate. “It encompasses all upfront costs like down payment, closing costs, financing fees, property taxes, insurance, maintenance, repairs, and enhancements.”

One of the primary ways to profit from real estate investments is through appreciation, where the property’s value increases over time. For instance, if you buy a house for $300,000 and its market value rises to $400,000 over five years, with additional expenses of $40,000 on improvements and $20,000 in rental income, and then sell it for $400,000, your ROI calculation would be: ($20,000 + $400,000 – $340,000) / $340,000 = 23.5%.

Beyond single-family homes, there are various residential property types to consider, such as condos, townhouses, and multi-family homes. Investments in alternative housing like tiny houses or accessory dwelling units (ADUs), as well as undeveloped land, also offer potential opportunities.

“The spectrum of real estate investment opportunities is vast and should align with individual goals,” notes Mark Hamrick, Bankrate’s chief economic analyst. “Each type of investment serves different objectives.”

ROI = (operating income + sale price of investment – acquisition cost) / acquisition cost

  • Resales and cash sales: Calculating ROI for cash sales and resale transactions is straightforward. Simply subtract your total investment cost from the final sale price (the gain), then divide this number by the investment cost. The result is your ROI.
  • Rentals: Owning a rental property provides steady long-term income. To calculate ROI for rentals, first estimate your annual rental income and subtract annual operating expenses such as insurance, property taxes, HOA dues, and maintenance costs. Then, use this formula to determine ROI: ROI = (annual rental income – annual operating costs) / mortgage value (i.e., the remaining mortgage loan amount).
  • REITs: REITs, or real estate investment trusts, offer a passive approach to real estate investment. Instead of individual property calculations, investing in an REIT involves purchasing shares similar to stocks, with dividends earned from the trust’s income (some REITs are publicly traded).

There are several metrics used to assess potential investment profitability, often combined to provide a comprehensive analysis. Other common metrics include:

  • Capitalization rate (Cap rate): This calculates the annual, debt-free rate of return from a rental property. The formula involves three variables — net operating income, property value or price, and rate of return — where any one can be derived using the other two.
  • Internal rate of return (IRR): IRR is a more complex calculation than ROI, measuring the annual rate of return over a specific time period rather than the entire ownership period.
  • Cash-on-cash return: This straightforward formula compares the annual pretax cash flow from a property to the total cash invested. Cash-on-cash calculations typically assess returns over a specific timeframe, such as one year.

Several external factors can significantly influence the potential profit or ROI of a real estate investment. One major factor is the prevailing market conditions. In a seller’s market with limited inventory, property prices tend to rise, thereby potentially increasing ROI for investors.

The initial purchase price of a property also plays a crucial role in determining eventual profits upon sale. Generally, a higher purchase price reduces the net profit unless the property appreciates substantially in value.

Mortgage interest rates are another critical consideration. Higher interest rates can lower property sale prices as they deter potential buyers, impacting the profitability of a real estate investment.

Location is paramount in real estate. Properties in desirable neighborhoods with good amenities like schools, parks, and easy access to transportation typically command higher sale prices, thereby enhancing ROI. As Mark Hamrick emphasizes, “Location, location, location” remains a pivotal factor influencing investment returns.

The cost of building materials for construction or renovations can also affect ROI. Increases in material costs inflate project expenses, potentially reducing overall profits when the property is sold.

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