Return on investment, also known as ROI is the single most important metric to consider when you’re assessing a real estate investment. What is ROI, and why is it significant?
ROI is a formula used to evaluate the performance of an investment. ROI is the way you can measure how much profit a property is accumulating. Typically, ROI is calculated by dividing the net profit of investment by the amount of money invested.
But that’s just the basics. There are a few different methods real estate investors use to calculate return on investment. I find that using a simple, conservative formula not only allows me to quickly analyze the return on a property, but it also allows me to be prepared for any potential expenses that may arise.
I always subtract 40% of my annual rental income to account for vacancies, repairs, or expenses that could occur throughout the year. You might think that sounds like too large of a portion, but it gives me peace of mind. I don’t have to worry if something goes wrong at my properties. If a furnace goes out, I want to know that the money is there to replace it. Expenses are inevitable, so I like to prepared.
Also, I’d rather be surprised at the end of the year when my investments are more profitable than I had anticipated. You know that feeling when you find a $20 bill in a jacket you haven’t worn in a while? It’s like that, but better.
So how does this formula work? Multiply the monthly rent by twelve to determine annual rental income. Then multiply the annual rent by .6 to account for those expenses. Then divide that figure by the total cost of the house.
Here’s an example: let’s say you purchased a house for $40k, and it rents for $700 a month.
$700 x 12 = $8400
$8400 x .6 = $5040
$5040 / $40k = 0.126
In this example, your ROI would be 12.6%
That’s a great ROI! For my properties, I like to earn a minimum of 10-12% ROI, so this example is a property I would definitely purchase. You should always estimate your ROI before you make an investment, it's important that your properties cash flow.
But what if you have to take out a loan? How does that change things? Check out this blog post about evaluating debt service.
Want to know more about real estate jargon? We’ve got a podcast episode for you!