What is an Expected Return on a Real Estate Investment?
We break down the two ways to calculate return on investment (ROI) for a real estate investment and which factors can influence the rate of return.
By Emily Southey | 9 minute read
If you’re thinking about investing in real estate, you may be wondering what kind of a return you can expect. A return on investment (ROI) is a measurement of how much money a person earns on an investment, whether it be a stock or a piece of real estate.
What Is an ROI in Real Estate Investing?
As mentioned, a return on investment helps investors measure how much money they have earned or could potentially earn on a given investment. The metric can be incredibly useful for real estate investors who want to identify whether an investment property is worth their time. ROI allows investors to predict the profit they could earn on a piece of real estate as a percentage of the amount spent on the initial investment. Essentially ROI can show how much an investor’s money has grown (or might grow). ROI is a tool that can be used to measure the performance of all kinds of real estate investments, from commercial and residential properties to real estate investment trusts (REITs).
For example, if you bought a condo for $100,000 and sold it for $110,000 a year later (without paying any fees on the transaction), your ROI would be 10%. This means that on top of making back the principal amount, you would have earned an additional 10% of income. Though calculating ROI for real estate investments is often far more complicated, this example gives you an idea of how it works.
Ultimately, ROI provides an objective look into how profitable an existing real estate investment is or how profitable a potential investment might be. It can help investors predict performance before biting the bullet, compare multiple investment properties against each other, and more.
How to Calculate ROI for Real Estate Investments
There are two main ways to calculate return on investment for real estate investments. These two methods are the cost method and the out-of-pocket method. We outline each method and provide simplified examples below.
Method #1: The Cost Method
The first way to calculate ROI for real estate investments is by using the cost method. The cost method calculates ROI by dividing the property’s investment gain by its initial costs. To successfully use the cost method to calculate ROI, investors must divide the total gain by the total costs related to the property (this includes the purchase price, repairs, rehabilitation, closing costs, and more).
For example, if you bought a rental property for $200,000 and subsequently spent $50,000 on repairs and updates, resulting in a new value of $300,000, your investment gain is $50,000. This is determined by subtracting the $50,000 spent on repairs from the overall property value increase (or investment gain) of $100,000. To determine the ROI as a percentage, you would then divide the gain ($100,000) by all the costs related to the purchase, maintenance, and rehabilitation of the property (in this case, $250,000). Therefore the ROI is $100,000 ÷ $250,000 = 0.4 or 40%.
“From vacancy rates to operating expenses, several factors can influence the return on investment of a property.”
Method #2: The Out-of-Pocket Method
The second way of calculating ROI for real estate investment is using the out-of-pocket method. This method is often favoured by real estate investors as it typically results in higher returns. To calculate ROI using this method, investors must divide the current equity of the property by its current market value. Please note that this differs significantly from the cost method, which divides the investment gain (rather than the property’s equity) by the total costs of the property (not its market value).
An example of the out-of-pocket method in action is as follows: As with the above example, let’s say you purchased an investment property for $200,000, completed renovations, and it is now valued at $300,000. However, in this example, you financed the purchase with a loan of $20,000. Therefore, your out-of-pocket expenses are $20,000, plus the cost of repairs and updates ($50,000), for a total of $70,000. With $70,000 in out-of-pocket expenses and the value of the property now standing at $300,000, your potential profit (or equity position) is $230,000. To calculate your ROI from here, you would divide $230,000 by $300,000, which is 0.76 (or 76%). Therefore, using the out-of-pocket method, you end up with an ROI that is nearly double the ROI calculated using the cost method. The key difference between the two was the loan, which was leveraged in the out-of-pocket method as a means of increasing your ROI.
Calculating ROI for Rental Properties
If you intend to rent out your investment property to a tenant and earn rental income, there are a few extra steps you must take to accurately determine a property’s ROI. First, you must estimate your annual rental income. If you don’t yet own the property, you can do this by researching similar rental properties in a similar neighbourhood. In completing this step, find out the average monthly rent for the same type of property you plan on buying and multiply it by 12. This will give you an estimate of your annual rental income.
With an estimated annual rental income, you can then estimate your net operating income (the latter is the annual rental income minus the annual operating expenses, such as property taxes, condo association fees, maintenance, insurance, and more). To proceed using either calculation method above, you will need to include your net operating income in the total costs of the property (for the cost method) or the total cost of out-of-pocket expenses (for the out-of-pocket method).
Factors That Can Impact Your Return on Investment
From vacancy rates to operating expenses, several factors can influence the return on investment of a property. We outline a few of the most common factors below.
- Purchase Price: The amount of money you spend on the purchase of the investment property is one of the key factors impacting your return on investment.
- Sale Price: Similarly, the sale price is another key metric that impacts your ROI, which will ultimately be determined by timing and market conditions at the time of the sale.
- Vacancy Rates: The occupancy level of the investment property can have a major impact on ROI because it directly relates to rental income. If a certain building or neighbourhood has high vacancy rates, this decreases your odds of finding a tenant, which could translate to less rental income, hurting your overall ROI.
- Operating Expenses: The amount of money spent on operating expenses also has a considerable effect on ROI. Properties with more expenses (for example, higher condo association fees, property taxes, insurance rates) may produce less ROI than ones that are run more cheaply or efficiently.
- Average Rental Rates: The average cost of rent is another factor impacting ROI. If you purchase an investment property with the purpose of renting it out to a tenant, then the amount of rent you are able to collect will play a major role in your overall return on investment. Any change in average rental rates, whether positive or negative, will impact your bottom line.
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Other Measurements of Profitability Beyond ROI
You might be surprised to learn that there are several other ways of determining an investment’s performance beyond ROI. The capitalization rate, cash-on-cash return, and internal rate of return can all be used to identify the potential profitability of an investment.
The capitalization rate, or cap rate, of a property can be determined by dividing the annual net operating income by the property’s current market value. Convert this into a percentage and this figure can help investors determine how long it will take for their investment to break even. It can also help them compare the profitability of different properties using a more simplified method that doesn’t take into account complex metrics like mortgage rates.
Another way to measure the profitability of a real estate investment is through a cash-on-cash return. This method sees investors calculating the amount of money they earn back compared to the actual value invested. To calculate this metric, you would compare your net operating income against the amount of money you paid upfront (for example, your down payment). Calculating the cash-on-cash return of a property can help an investor identify how much of a down payment they can afford to spend while remaining profitable.
Internal rate of return
Lastly, the internal rate of return (IRR) is another measurement real estate investors can use to determine the profitability of an investment. An IRR is specifically used to predict the future value of an investment. It does this by calculating the projected growth based on the amount of risk involved and how profitable your investment is likely to be. Calculating a property’s IRR is a little bit more complicated than the above two measurements, but there are plenty of free calculator tools online to help you.
Frequently Asked Questions
Does a higher return on investment in real estate equate to higher risks?
Generally speaking, yes, a higher return on investment in real estate may translate to higher risk (that is, greater potential for loss). That said, there are ways you can mitigate your risk, such as by working with an experienced realtor and doing ample research into the market and neighbourhood before choosing an investment property to buy.
Does diversification increase my expected return on real estate investment?
Yes. Although every investor is different, diversification can actually increase your potential real estate returns while simultaneously reducing your overall risk. Ultimately by owning multiple real estate assets that perform differently (especially if you own different types of properties, such as a mix of commercial and residential or condos and single-family homes), you can stabilize your portfolio and improve your returns.
If my expected return on real estate investment is lower than I expected, how can I increase it?
To increase an expected return on a real estate investment, an investor has several options. They can complete renovations or updates that increase the value of the property (just make sure you are investing in worthwhile renovations known to boost property value, such as kitchen or bathroom updates). Improving the curb appeal of a home is another way to boost your ROI. It can usually be done relatively quickly and cheaply through small fixes like repainting the front door, washing the windows, basic landscaping, or power washing the driveway. An investor can also choose to look for a property in another neighbourhood. Location is one of the key determinants of property value, so be sure to do optimal research and buy a property in an area with high average rental rates, low vacancy rates, a low crime rate, and lots of amenities, such as proximity to schools, cultural centres, and public transportation. If the location isn’t the problem, consider a different property type altogether. The best type of property to invest in changes with the market. With a little research, you might discover that the single-family home you had your heart set on may not currently be as profitable as a condo, townhouse, or apartment.