Real estate investing is among the most lucrative and reliable ways to build wealth and represents an exciting opportunity to expand your investment portfolio while making impressive returns on your investment. It’s no wonder why many ambitious investors are eager to learn about real estate investing and the kind of returns they can expect from purchasing different properties.
However, like any other investment, investing in real estate isn’t without its risks. That’s why it’s so important to understand the foundational concepts and calculations you need to make before buying property or investing in any form of real estate.
Let’s explore some of those fundamental ideas so that you will understand a few ways to calculate the return on your real estate investment based on the purchase price.
Understanding Return on Investment (ROI)
Return on investment, or ROI, refers to the profit made on an investment as a percentage of the cost of that investment. Understanding and calculating your expected return on investment is a crucial step in understanding which real estate investments make sense. It also provides a benchmark through which you can compare the profitability of real estate investments with other investment options such as stocks, bonds, or other financial instruments.
Luckily, there is a simple formula you can use to calculate the ROI on a real estate property. To calculate the return on investment, subtract the cost of investment from the gain of the investment. Then, divide that number by the cost of the investment.
Finally, you can multiply the result by 100 to put it into the form of a percentage. ROI is typically expressed as a percentage of the cost of an investment.
This equation is simple enough, but keep in mind that in the case of real estate, there are many factors you must consider when determining your investment. In the case of a cash transaction, calculating ROI is a bit simpler.
After calculating the total investment costs including the price of the property, closing costs, renovation costs, and maintenance costs for the year, you can subtract that from the total rental income you’ve received from the property to calculate your annual return. The annual return can then be divided by the total investment cost and multiplied by 100 to determine your annual ROI.
Calculating your ROI for financed purchases of real estate will be more complex. That’s because you’ll have to include your downpayment, interest, closing costs, mortgage payments, taxes, utilities, and insurance when calculating the cost of your investment. Other factors such as inflation should also be considered when calculating ROI.
There’s another additional element you should consider when calculating your ROI on a real estate investment. That’s the equity you own in the property you’re buying. Not every investor chooses to include home equity in their ROI calculations but it’s crucial that you know how to do so and understand the importance of home equity in general.
It’s important to note that owning equity is different from the cash-in-hand liquidity that you can enjoy from rental income. However, it still influences your net worth and the amount of leverage you have at your disposal for future loans and investments.
You’ll need to understand the amortization schedule of your loan and how much of your principal you pay off each time you make a mortgage payment. Then, you can choose to include the amortization and home equity as part of your annual return when calculating your ROI using the same formula mentioned above.
The capitalization rate is another important factor when calculating the returns on your real estate investments based on the property purchase price. That’s because, in some cases, you might not know exactly what sorts of annual returns you can expect on a property. As you’ll recall, you need the annual return or rate of return of a property in order to calculate your ROI.
First, you’ll need to calculate the net operating income of your property, which is the revenue produced by the property minus all operating expenses. Net operating income excludes interest and principal payments, as well as other capital expenditures and home equity. After you calculate the net operating income of your property by subtracting operating expenses from real estate revenue, you’re ready to calculate the capitalization rate.
To determine the capitalization rate, simply divide the net operating income of the property by the current market value of the property.
Some real estate professionals choose to calculate the capitalization rate slightly differently. This school of thought involves dividing the net operating income by the purchase price of the property. This method can produce a slightly less accurate capitalization rate, particularly if used years after buying a property since market values of real estate tend to fluctuate.
The One Percent Rule
The one percent rule is a famous rule of thumb that is often used by investors to narrow down their options when considering which properties to invest in. The rule states that a property should rent for approximately one percent of its total purchase price.
It’s important to note that the rule is designed to include the total purchase price of a property including closing costs, and all renovation costs needed to get the property ready to rent out.
It isn’t wise to make real estate investment decisions based solely on the one percent rule, but it is useful to know and understand as a tool for investigating which properties might be worth considering an investment in.
Remember, the One Percent Rule is just a general rule. It’s a good place to start, but other factors must always be considered when determining how much rent to charge your tenants.
Researching Market Values and Consulting Experts
Whether you’re deciding which properties to consider investing in, calculating the cap rate of a property, or determining your ROI for a real estate investment, it is crucial to research the real estate market in the area you’re buying property in. Keep in mind that your ROI from a real estate investment will be dependent upon how much rental income you expect the property to generate.
In order to develop a good idea of that, you have to do a deep dive into the currently offered rents in the area, as well as various demographic details of that region. This includes the historical data related to the local real estate market, neighborhood safety, education, and price ranges of comparable properties.
In many cases, it makes sense to work with a real estate professional or firm that will conduct this in-depth research for you and advise whether a given real estate makes sense and aligns with your goals or expected ROI.
To sum up, calculating real estate investment returns based on purchase price can be tricky, but once you understand some fundamental concepts and simple formulas, as well as how to conduct a market analysis, it becomes a matter of simple arithmetic. Knowing these basic terms and being familiar with the ideas they represent will empower you to make better investment decisions, whether you work with real estate professionals and partners or endeavor to invest on your own.
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