Real estate investing is broadly accepted as a long-term way to build generational wealth. And while most experts will attest to this fact, it only applies to intelligent, profitable investments that generate high year-on-year returns and cash flow.
This is why, as a real estate investor, one of the most important things you can do when purchasing a property is to run the numbers diligently to ensure that the real estate investment you’re making will give you a high return and continue to generate a profit for a number of years—and decades—to come.
Knowing how to calculate your return on investment is critical, and in this article, we’re going to discuss what return on investment means, how to calculate the profitability of an investment, what ROI metrics to use, and how to know whether a property will offer a good return on investment in the long term.
What is Return on Investment?
ROI, or return on investment, is a metric calculated to determine the profit earned on any investment, including a real estate investment, after deducting all associated costs.
When speaking specifically of real estate, the return on investment is arrived at after deducting the purchase and initial costs of the home and any additional expenses incurred, such as repairs or remodeling costs, from the current value. ROI is not realized until the property is sold, though it is an important number to keep in mind when purchasing to see if it can become a profitable asset.
The simple ROI formula is:
ROI = (Present value of investment – Cost of the investment) / Cost of total investment
Or, to say it even more simply:
ROI = Net income on investment / Cost of the investment
While the formula is simple, calculating a meaningful ROI percentage for an investment property is not. It is challenging because numbers in real estate investments are often estimates or guesses and can be hard to predict with absolute certainty.
It’s also important to consider how many ways to purchase a property and calculate the net profit. While some investors will purchase a property outright with cash, others will get a mortgage, adding to ongoing expenses but resulting in less upfront cost.
Again, you may choose to offer your property as a short-term or long-term rental or simply hold it for appreciation, and how that property is used will also impact its profitability.
So, while ROI is an important number and one that every real estate investor must consider, it’s essential to note that there are many ways of arriving at this number and that if you’re looking for accuracy, you might want to consider calculating the ROI in addition to several other numbers at your disposal, such as capitalization rate, internal rate of return (IRR), cash-on-cash return, and annualized ROI, which also considers the length of time you hold the initial investment.
If you’re an experienced investor or real estate business owner, you also want to look at corporate finance numbers to determine how investment costs and investment gains impact your overall portfolio. You’ll want to calculate Return on Assets (ROA), for instance, which is the measure of the profit a company or property makes relative to its assets or costs over a period of time. Return on Equity (ROE) measures a company’s net income divided by its shareholders’ equity.
Of course, a negative ROI number would indicate that this is a loss-making property and you’d be well served to think of this particular investment as best avoided.
You can find a simple Return on Investment calculator here.
Understanding ROI variables
The key thing about the ROI on real estate investments, which makes them different from other investments, is that real estate ROI can often depend highly on variable factors, including local market conditions, type of property (single-family homes, multifamily units, vacation rentals, or commercial real estate) and how much rent a property can command. These limitations of ROI can be influenced by factors such as:
What will impact ROI on a property most are the overall real estate market conditions. In a seller’s market, there is limited inventory available, which means that a large number of buyers will be competing for a small number of available properties, pushing the purchase price up over a certain time frame. On the other hand, a buyer’s market will slow down both sales and prices.
Market conditions at the time of purchase matter are easy to overlook, but they matter too. If you bought a property in a seller’s market, you might have less gains to make and, therefore, a lower ROI unless the market appreciates significantly.
Properties in metropolitan cities such as New York and San Francisco, tourist attractions such as Joshua Tree, and billionaire favorites such as Palm Beach appreciate faster than regions in other parts of the country. This can significantly impact the ROI in the short and long term. A residential property close to excellent schools will have both high sale and rental valuation, while an apartment near a highway will get fewer people interested and, therefore, lower prices.
Costs of purchase and maintenance
How much you paid to purchase a home will factor into your ROI calculations and what you spent to fix it up and renovate it. Ongoing maintenance costs are essential to factor into any calculations.
Crucially, mortgage interest rates will also impact your profits when dealing with different investment opportunities. When interest rates are high, your profits will not only decline in real terms, but your house prices may also go down due to the impact on the overall real estate market. Also included in this equation will be taxes–including the capital gains tax incurred when you hold a property for over a year before selling.
ROI for different types of investments
When calculating ROI for a real estate investment, it’s also important to look at the type of real estate investment. For instance, ROI is often a straightforward calculation in cash and resale transactions. You calculate your profit by subtracting your expenses, which includes the price you paid for the property as well as any money you’ve spent on it from the total revenue. You then divide that number by your total cost or investment.
For a financed rental property, however, you’ll need to calculate your projected annual rental income and operating expenses. These include insurance, property taxes, HOA dues, and day-to-day maintenance costs. You’ll also want to factor in the marketing and legal costs of finding and vetting tenants.
What is a good ROI for real estate investors?
While there is no one number that’s considered a good ROI for real estate investors, there are a few benchmarks to consider when evaluating a property’s long-term potential.
Typically, what an investor might consider “good” ROI is a number that matches or exceeds the average returns on a stock market index, such as the S&P 500. Historically, the average annual return on the S&P has been approximately 10%, so a number greater than 10% would be considered an excellent real estate investment.
In the US, the average annual return on investment for residential real estate is 10.6%, while commercial real estate fares lower at 9.5%, and REITs (Real Estate Investment Trusts) come in at 11.8%. Arizona has the highest one-year ROI on residential single-family homes, with 27.42%, followed by Utah at 27.05% and Idaho at 27.02%.
While the numbers can act as good guidelines, don’t forget that what one investor considers a good return on investment could be below average for another. In addition to the many variables that will impact these numbers, as we’ve already discussed, an appetite for risk will also play into these decisions and numbers. The more risk you’re willing to take as an investor, the higher the ROI you can expect. Conversely, risk-averse investors may have more certainty and a lower ROI as a result.
How to maximize your real estate ROI
As an intelligent investor, maximizing the ROI from your investment property should be one of the top things you look at when making a real estate purchase. Here are some things to consider that will help you increase your ROI.
- Keep the property in good condition: Especially when renting out your property, it’s important that you perform regular property maintenance and renovations. This will ensure you don’t get hit with unexpected and costly bills because of issues you’ve missed.
- Reduce operating costs: It might sound contradictory to the point above, but you want to reduce your operating costs whenever possible. This is more than just about expenses, though. Keep on top of mortgage and insurance rates and have them reduced when you can, pay for quality upfront so that things don’t break or malfunction often, and when required, hire professionals, such as real estate agents and management companies, to do what’s required faster.
- Do your research: When looking for investment properties, do your research by looking at similar properties in the same or similar neighborhoods. By looking at the numbers on those properties and using that as a template, you’ll be able to arrive at more accurate estimates for your potential purchase as well.
The bottom line
While purchasing a physical property is a fantastic way to invest in real estate and build generational wealth, it is not the only way. Through Arrived, you can own shares in real estate properties around the US, no matter whether you have $100 or $100,000 to invest. Our mission is to give everyone—regardless of background and income level—a chance to get on the property ladder.
Our investments allow you to co-own properties with other investors and get both the benefit of appreciation as well as monthly cash flow, with a high return on investment, right away. To see how easy it is, browse our listings and sign up to start today.