To be an informed investor, you have to have a working knowledge of ROI, or Return on Investment. Just as you would calculate a mortgage and the other costs associated with it before purchasing a property, you should also calculate ROI.
In simple terms, ROI is the percentage of money returned to you after deducting all costs related to the investment. It’s your profit, as a percentage of your investment.
How to Calculate ROI for Income Property?
There are two ways to calculate ROI, and you don’t have to be an accountant for either — although it’s always a good idea to get the advice of your accountant in any major purchase.
The Cost Method – ROI is calculated by dividing profit by your invested capital.
Example – Suppose you purchased a home for $100,000. You invested $50,000 in repairs and renovations. You’re delighted with the new appraisal, which values the property at $200,000, leaving you with a $50,000 profit.
Take the $50,000 profit, and divide it by your capital invested of $150,000 ($100,000 to purchase, and $50,000 to renovate.)
$50,000/$150,000 = .33 or 33%
Thirty three percent is a great return on your money, wouldn’t you agree?
The Out of Pocket Method – This method takes into account the power of OPM (Other People’s Money.)
We’re still going to use the same $100,000 house, but purchase it with a mortgage. This way, you only have to use $20,000 of your own money. With the same $50,000 in renovation costs, your out of pocket investment is $70,000. The bank is paying $80,000.
The house is worth $200,000 after you’ve renovated it. You only paid $70,000 out of pocket, and you earned $50,000 in profit.
$50,000 profit/$70,000 capital = .71 or 71%
71% Return on Investment is fantastic. Numbers like that make the news with stocks, but are much easier to obtain with real estate. This is great income on a short term renovation. But it is important to understand that your time is valuable as well.
If you do not have time to do renovations, another option is to buy property that has already been renovated, and hire a property management company to manage the rental. This way you can enjoy the ultimate leverage by letting someone else pay down your mortgage.
For example, you could purchase a $100,000 home with a $20,000 down payment, and rent out the property for $1200 per month. Depending on where and what you buy, you could receive approximately $5000 in annual rental income. If you put all that cash flow toward paying off the loan, you could have it paid off in 12 years.
Let’s calculate that ROI. You put in $20,000. After 12 years, you own a $100,000 home outright.
$80,000 profit/ $20,000 = 4
Yup, you quadrupled your money in 12 years.
Plus, you still get that $1200 monthly rental income for the rest of your life (or more than that if rents increase over time).
If you would like more information on where to buy the best long-term rental properties, schedule a strategy session with one of our investment counselors here. It’s free.