How Do You Calculate The Rate Of Return On Your Real Estate Investment?

How Do You Calculate The Rate Of Return On Your Real Estate Investment?

Posted by on Oct 11, 2020

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There are many ways to calculate the return on a real estate investment. Two main categories make up the calculations: holding period return (i.e., buy to sell) and performance metrics (i.e., ongoing basis - property not yet sold). For this article, we’ll go over how to calculate the holding period return using an all-cash transaction and then another with debt financing.

Holding Period Return

The simple holding period return (i.e., simple - meaning ignoring time value of money) is the simplest real estate return calculation and what most people think of when return comes to mind. The calculation works just as well on other types of assets.

The holding period calculation is a return across a defined period. That time being the purchase date to the sale date of the property. Costs must be included in the calculation as well.

Let’s say you bought a property for $300,000 in 2015 and paid cash. You then invested $50,000 in updates. That’s a total investment of $350,000. In 2019, the property sold for $400,000, generating a profit of $50,000. What was the return on this property? Here’s how to calculate it using the cost method:

Return = [equity + other income] / [initial investment + cost]

= $50,000 / [$300,000 + $50,000]

= 14.29%

Return is always expressed as a percentage. Is 14.29% a good return? That will depend on what you’re comparing it to. In other words, which benchmark are you using? The benchmark might be similar property comps in the same area. If your return is higher than your benchmark, then yes, it is a good return.

What about rental income? Yes - that is also included in the calculation. Adding rental income will increase the property’s return because we are simply increasing the numerator. Math takes over from there. Rental income is included for the entire holding period. If the property generated $750/mo in rental income, its annual rental income is $9,000. Using a four year holding period, that’s $36,000 in rental income. Rolling that back into the equation, we have:

= [$50,000 + $36,000] / [$300,000 + $50,000]

= 24.57%

A sale doesn’t have to take place to calculate return. If you are in year 3 of 4, you can use the same calculation. Instead of a sale price, you’ll use the current market value.

The Effect Of Financing On Returns

It’s more common to use financing instead of all-cash for real estate investments. Financed investments have the potential to generate higher returns. The main reason is that debt is leverage. In addition to your money, you’re using someone else’s money to create the initial investment amount. A larger initial investment opens the door to more investment opportunities.

Let’s use the same investment example, but we’ll inject debt into the deal this time. Here’s the breakdown:

Purchase price: $300,000

Initial investor equity: $30,000 (down payment)

Debt: $270,000

Upgrades: $50,000

Debt Servicing: $43,000

The initial outlay on the property, including upgrades, is only $80,000. It still sells for $400,000. The gain remains $50,000, but the investor is now leveraged, and we’re adding debt servicing as a cost. Here’s what the calculation looks like:

= ($50,000 - $43,000) / ($30,000 + $50,000)

= 8.75%

This is called the out-of-pocket calculation. Keep in mind that leverage is a two-way sword. If the investment goes bad, your losses can also be amplified, just as your gains are amplified when everything goes right.

These examples don’t go into detail about the various costs. There are legal fees, upkeep/maintenance, and unexpected expenses that will all come into play. However, the formulas won’t change.

These hypothetical examples are demonstrating a mathematical principle. They do not illustrate any investment products and do not show past or future performance of any specific investment.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.

 


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