What Does ROI Mean?
If you’re just starting to learn about investing, you might be asking yourself, “What does ROI Mean?’
Calculating the ROI (return on investment) is an important litmus test for real estate investors. It quickly reveals the gains the investment will yield, and it’s an adaptable measure. Not only is it used for ballpark estimates, it provides results regardless of the level of detail used for the inputs.
The term applies to the net gain you receive from an investment, after all the expenses associated with it have been subtracted. Properties or projects that don’t require much by way of time or money upfront will show a higher ROI.
When financial analysts run the numbers to estimate profitability from real estate investments, they use the ROI, along with other complex inputs that include the cost of money (interest paid), overhead expenses, and capital improvements and investments.
See also How to Find and Invest in High ROI Properties
How to Calculate ROI
You can quickly calculate the ROI for properties by subtracting the expenses you’ll incur over a year from the income you received.
- If you paid $200,000 in cash for an investment home and rented it for $1,600 a month, your income over a 12 month period would be $19,200.You incurred $4,000 in property taxes and insurance on the property, which gave you a net income of $15,200. To find the ROI, divide $15,200 by the purchase price by $200,000, which yields a ROI of 7.6 percent for the year.
- The method for calculating the ROI for a financed property is somewhat different. Assuming the same monthly rent, you’ll subtract the total of your payments (which include principal, interest, taxes and insurance) and any other expenses associated with the rental.Subtract the annual total of your expenses (assume $6,000) from $19,200, the total rent you received. Divide $13,200 by the $40,000 you put down, which results in an ROI of 33 percent for the year.
The ROI for a financed property exceeds the ROI for one you own because your cash outlay is significantly lower in the first year. Over time, however, the profit you make on properties you own outright will always be higher than those that are mortgaged.
Keeping ROI in Perspective
The ROI shows you the percentage you stand to gain from an investment based on the amount you spend and the income it generates. However, ROI doesn’t necessarily reflect all the financial benefits of property ownership, especially when it comes to tax benefits and long term appreciation.
See also How to Calculate Rental Property Cash Flow
Besides the largely passive income stream it generates, nearly all of the expenses associated with owning and renting residential property are tax deductible, including almost all travel expenses. It’s also possible to shelter capital gains from the sale of such properties by either claiming a one-time exclusion or reinvesting the profits.
A management agency also increases the ROI by minimizing your risk as a property owner. They carefully select tenants based on their ability to pay, credit-worthiness and past rental histories. They’re also careful about record-keeping so that there’s no year-end scramble to put the books in order.
Unless you treat property management and improvements as a hobby or have access to wholesale materials and contractors, you may find that engaging a property management company from the start increases your ROI. These companies specialize in maximizing the value of homes for the market.
Professionals in this niche identify properties with high-profit potential to maximize their potential for income generation as rentals and ultimately, as for-sale properties. Timely maintenance and critical reinvestments in the property give them an edge when it comes to profit-taking throughout their lifecycle.
Talk to one of our investment specialists to learn how JWB can help you earn passive income through long term real estate investing.