Calculating ROI for real estate investment: rental vs. capital gain ROI.
One of the critical questions that each experienced real estate investor analyzes before putting money down is: how much return on my investment will I get? Novice real estate investors looking for their first investment property should resist the urge to invest in "any" property. The urge to join "the secret club" of real estate investors is big, and it may feel at times that you just need to buy a second property, rent it out, and you are all set.
With a recent spike in real estate prices in the USA and Canada, many novice real estate investors are excited to jump into buying their first property and opt to buy properties with zero or negative cash flow. The idea behind such investment choices is the hope that real estate prices will continue to grow in the next few years. Thus, a negative cash flow today would be offset by a future capital gain from the sale of the property. This is definitely the wrong way to start your real estate investment path.
I am not going to preach about housing bubbles, overbought markets, etc. However, there is a risk of increasing interest rates in 2022 due to high inflation in both the USA and Canada. With higher inflation, the governments will have to cool off the economy. To do so, the government will aim to reduce the amount of cash available in the economy. The governments are expected to make borrowing money more expensive, that is, raise the prime rates. With higher prime rates, the mortgage rates will follow, meaning fewer people can get a mortgage to buy the properties at such high prices. This may slow down the increase in housing prices in the next few years.
Having identified the risk, we have to acknowledge that avid real estate investors know that there are areas and types of properties that will grow due to different factors: the appeal of the area, increasing population, booming businesses, the change in the profile of buyers, changes in transit, etc. But they also evaluate their real estate investments in a very rational way that we will discuss in this post.
How to calculate return on investment for real estate properties?
There are plenty of ways to invest cash and money you can borrow. With the current prime rates, investors can borrow money cheaply, invest that money, and still make a hefty profit. Investors must constantly evaluate the different investment options and find the option that will bring the most return on investment (ROI). The opportunities to invest are many, be it stocks, dividend stocks, mutual funds, bonds, ETFs, precious metals, commodities, lending the money to others, and real estate investing, to name a few. To grow your wealth the fastest, you need to understand the average returns and their volatility for the available investment options. While storing all your free cash in a savings account or bonds may be a good start, it will likely not get you far in terms of wealth creation.
Real estate investing proved to have made more millionaires than any other type of investment over the past few decades. The key reasons for this are higher annual returns and less volatility (read: risk). This allows growing your wealth faster, sustaining the gains, and reinvesting them more frequently and with lower risk. The ability to reinvest your profits is a significant factor in increasing your wealth. For example, if you invest $100,000 at a 10% annual return, this means you will have $110,000 to invest in the next year. If you can again achieve a 10% return, you have $121,000 to invest in the following year. This compounded effect of getting a return on the higher amounts every year results in a quick multiplication of your money.
The size of the annual return can have a very drastic impact on the speed of wealth accumulation. Below are the rates of net worth accumulation at 6%, 10%, and 15%. The fight for every extra annual percent return makes a huge difference in the long run.
The above table assumes that you can immediately reinvest all profits at the same rate of return.
How to calculate return on investment for real estate properties?
There are different ways you can invest in real estate:
Buy to rent and wait for the property price appreciation
Buy to renovate and flip
Buy to hold
Buy to split the property and sell in parts
Buy at pre-construction phase to sell later
Depending on the way to invest in real estate, there will be different factors in play that will impact the calculation of the return on investment.
How to calculate the rate of return on investment in a rental property?
For our calculations, we will use the following case. You bought a house for $550,000. To buy the house, you provided a downpayment of $110,000. For the remaining $440,000, you obtained a mortgage at a 3.5% rate and a 30-year amortization. You also had to invest $15,000 in cash to buy the new appliances and renovate the place. The house has an apartment in the basement with a separate entrance. You rent out the main part of the house for $2,200 a month and the basement for $900 a month.
To find the rate of return for a rented out property, the formula is:
ROI = Annual gross income from rent / Initial investment
Annual gross income from rent is calculated as the income you get from rent less any costs you incur on the property.
Your annual income statement may look like this:
Maximum possible income from the property ($2,200 * 12 months + $900 * 12 months) | $37,200 |
---|---|
Mortgage payments ($1,975.80 * 12) | $23,710 |
Property Insurance | $780 |
Property tax | $1800 |
Garbage collection | $150 |
Heat, electricity, water bills | $0 |
Large repairs, renos, and appliances budget | $2000 |
Small repairs | $350 |
Losses for idling basement for a month | $900 |
Property management | $1000 |
Annual net income from rent | $6,510 |
In our assumptions, we incurred small repairs and fixes during the year. We also put aside $2000 every year for major issues with the house, replacement of worn-out appliances, renovations after the tenant moves out. While you may not incur these expenses every year, it is wise to put this money aside and include this amortization amount into your calculations of the return on investment. The tenants pay for heat, electricity, water bills.
We also incurred an idling loss as we were looking for a proper basement tenant for a month. While you might have deducted this amount directly from the first line, "Maximum possible income from the property," it is good to know your best-case scenario with the full occupancy for the year. Some investors prefer to include a certain idling amount every year, similar to the budget for repair, renovations, and appliances. The idea is simple: you may be OK this year and the next, and then a tenant moves out, and you idle the place for two months to have the renovations done. Instead of showing a big drop in income for that year, you may choose to spread it.
Some investors also include property management costs in calculations. The idea is to evaluate how many hours it would usually take to manage the property a year: the time it takes to find the new tenant, get the papers in order, collect payments, do the minor fixes, visit the place to check-in. Then you would multiply that by an estimated hourly rate. For example, you may estimate the hours needed for all the above at about 50 hours a year. The hourly rate is $25. Thus, you would include a property management cost of $1000. While you may choose to do the property management yourself for your first property, it still makes sense to include this cost in the calculation for two reasons:
You need to pay yourself. The time you spend on managing the property is taken away from you spending time with your family or working on your next investment opportunity.
Over time, when you have multiple properties to manage, you will have to outsource property management to a special company or find a person to help you. Thus, it makes sense to incorporate these costs upfront.
Now that we have calculated the net income, we can plug this number into our ROI formula to calculate the return on investment for our real estate investment:
ROI = $6,510 / ($110,000 + $15,000) = 5.2%
A good ROI for a rental property is usually above 10%, but 5% to 10% is also an acceptable range.
How do you improve your return on investment for a real estate property?
Now, the 5.2% may not sound too exciting for you. How can you improve the return on your real estate investment? If we look at the formula, there are 3 levers that we can use to do it: the initial investment, the rent amount, and the costs.
To change the initial investment, you may try to buy cheaper or look for a similar property that does not require renovations.
Increasing rent just because you decided to do so may not work since you will find tenants harder. To increase the rent, you may decide to do renovations, buy better appliances, and charge your tenants more. However, please note that this will also increase your investment, so you would need to run the formula to see the impact.
To reduce costs, you may try to find different suppliers for insurance, repairs, put in better clauses for damage to the property, and when the tenants have to give you notice. This may allow reducing the idle time and the major repairs/renovations when tenants move out. The biggest part of your costs is the mortgage payments. Reducing the price of a house, finding the best possible interest rates will likely have the biggest impact on your rates of return.
How to account for the property price appreciation in your return on investment calculations?
This is our more or less definite return for our real estate investment. However, you are likely also expecting that the property price will appreciate over time. How do we account for that? It is quite easy, but please note, the rental rate of return is pretty much fixed. The expected rate of return for the property price appreciation depends on market factors. That is why it is a bad idea to only rely on it while disregarding the rental rate of return.
For calculating the property price appreciation rate of return, you have to make some research and assumptions. Let's say, you looked at the past appreciation for the properties in this area and found that the prices were growing at an average of 3%. You also expect that the area will continue to attract people, and the rate will continue. Now, the trick is that while you invested only $125,000 (downpayment and renovations), the 3% growth is calculated on the price of the house ($550,000). So, for the first year, the return for your property will be:
3% * $550,000 / $125,000 = 13%
In 10 years, using 3% annual growth will be worth $740,000. This means you made $190,000 on your $125,000 investment. This comes to 9.5% annual compounded growth.
Now you just need to add this return to the rental return you calculated before:
9.5% + 5.2% = 14.7%
As you can see, your return on investment will reduce over time. For the first year, it was 13%, but later it will reduce. This is because after 10 years, you have a higher investment locked, and the 3% growth in property price is less return for your money. Ten years after you bought this property, you have $125,000 initial investment plus $190,000 in unrealized equity. The total equity you have locked in the investment is $315,000. The same year, the price of your property will grow 3% on top of $740,000. This means the increase is $22,200. Dividing $22,200 by $315,000 gives just 7% return. The same happens with your rental return, as the money you make every month is less return on your new equity. Thus, with time, it makes sense to reshuffle your properties, refinance to buy additional properties to make sure your rate of return continues to be strong.
How to calculate the rate of return on investment for a non-rental property? Rate of return on investment for fix-and-flip real estate investment.
The calculation of the rate of return on investment for the below types of real estate investments is straightforward since we just need to remove the rental income from the equation.
Buy to renovate and flip
Buy to hold
Buy to split the property and sell in parts
Buy at pre-construction phase to sell later
The ROI formula will be similar to the one we used before:
ROI = (Gross Income - Costs) / Investment
The trick here is to properly calculate the price you can sell the property for and the costs.
For example, in a fix and flip scenario, you need to have a good sense of the price you will be able to sell the property for after renovations, as well as the costs for renovations.
For our calculations, we will use the following case. You bought a house for $550,000. To buy the house, you provided a downpayment of $50,000. For the remaining $500,000, you obtained a private short-term loan (3 months at a 10% annual interest rate). You would usually expect the interest rates to be higher for short-term terms. You expect to sell the property at $610,00 after renovations.
Maximum possible income from the property ($630,000 - $550,000) | $60,000 |
---|---|
Mortgage payments ($50,000 * 10% * 3 / 12) | $12,500 |
Cost of materials for renovation | $12000 |
Labor cost (160 hours at $35) | $5600 |
Real Estate Agent Fee at Sale (2.5%) | $15750 |
Title Transfer Tax at Purchase | $8600 |
Legal Fees | $2000 |
Appraisal Fees | $350 |
Home Inspection Fees | $600 |
Net Income | $15,100 |
Since the fix and flip type of investment is rather short in nature, you would usually include all incurred costs in addition to the downpayment in the initial investments.
Our total costs from the above table amount to $44,900. The return on investment will be:
ROI = $15,100 / ($50,000 + $44,900) = 16%
However, please note that the return of 16% is only for the 3 months of work. Let's say it takes extra 3 months to find, buy, and then sell the property and get the money in your bank account. This means you can technically do another property flip this year. If you manage to get as good of an investment opportunity, your rate of return will be double at 32% for the year. If you are really good at making all your available money constantly work for you and reinvest both the original investment you had plus the profit, the rate would be actually even higher. This is due to the compounding effect. The first time you make 16% on $50,000 + $44,900. The second time, if you invest everything you have, you make 16% on $50,000 + $44,900 + $15,100. Thus your actual rate of return for the year may go as high as:
(1.16 * 1.16) - 1 = 34.6%
If you are able to fix and flip the homes faster (e.g., every 4 months), you would achieve an even higher annual rate of return on your real estate investments.
The calculations of the rate of return on the rest of the types of real estate investment will resemble the above calculations. Some of them will have less work to do and will have lower costs, but the idea is the same.
In summary, it is very important to properly estimate the income you can get from your real estate investment, the potential appreciation for the property, and the costs involved. A well-researched and calculated investment can bring a high return on your real estate investment. Novice real estate investors must properly calculate the costs and risks and lower their enthusiasm to come up with a balanced calculation of the ROI. Calculating the worst, normal, and best-case scenarios may make sense. Then you can evaluate if you can bear the worst-case scenario and the chances the worst-case scenario may happen.