How Finance Structure Affects Return on Investment (ROI) on an Investment Property

How Finance Structure Affects Return on Investment (ROI) on an Investment Property

Posted by on Apr 25, 2021

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Informed investors often make more prudent investment decisions that dovetail with their tolerance for risk, comfort zone, and financial goals. Compiling important facts about potential investments and sticking to your game plan are critical aspects of a well-designed investment philosophy.

There are many factors to consider when reviewing potential investment properties. Return on investment is a key performance indicator that can help investors gauge potential returns. Investors who can determine ROI on investment properties can alleviate some of the guesswork about their investment decisions.

Financial structure of a transaction also has a strong impact on potential ROI. Below we’ve included formulas you can use to calculate ROI on both all-cash and financed properties, as well as additional factors to consider, such as risk and holding times, that can affect potential returns on your real estate investments.

What is Return on Investment?

Return on investment is a measure in percentage of the money, gain, or profit investors are likely to receive in relation to their capital outlay on an investment property. ROI is a profitability ratio that can be applied across a range of investments with similar characteristics. All things being equal, investments with a higher ROI are typically more attractive for investors than investments that have a lower ROI.

Return on investment can be determined using the following formula:

Gain on Investment-Cost of Investment / Cost of Investment

Following are examples of calculating ROI on both cash and financed transactions using simplified numbers for clarity:

Calculating ROI on All-Cash Investment Property

Say you purchased an investment property for $100,000 in cash, and it needed some tenant improvements to make the space functional. Closing costs on the transaction and remodeling costs added up to an additional $10,000, bringing your total capital outlay on the investment to $110,000.

You lease the space to a creditworthy tenant, and for the next 12 months your investment property netted $1,000 in rent for a total rental income of $12,000. However, ongoing expenses such as utilities, property taxes, and insurance cost $200 per month, resulting in $2,400 of expenses for the year.

  • $12,000 in income - $2,400 in expenses = $9,600 in annual earnings
  • $9,600 return / $110,000 initial investment = 8.7% ROI

Calculating ROI on A Financed Investment Property

There are a few more steps involved to calculate ROI when financing is required.

You purchase the same $100,000 property as above, but you finance it with a mortgage. Lenders typically require at least a 20 percent down payment, which equals $20,000. Closing costs and tenant improvements add up to another $11,500 since there are slightly higher closing costs associated with financed transactions.

Your total capital outlay for this particular investment is $31,500: $20,000 down payment + $11,500 in additional costs. The fixed rate on your 30-year mortgage is 4%, resulting in a monthly principal and interest payment of $381.93. Now factor in the recurring monthly expenses of $200 (utilities, insurance, property taxes) for a total payment of $581.93 per month. Multiplied by 12 months, your annual costs are $6,983.16 per year. Your tenant pays $1,000 in monthly rent, resulting in a gross income of $12,000 for the year.

  • $12,000 in income - $6,983.16 in expenses and mortgage payments = $5,016.84
  • $5,016.84 / $31,500 = 15.9% ROI

While many investors are comfortable setting there, you also can include a consideration for the debt paydown to reach a more accurate total ROI for financed transactions. Simply add the total amount paid in principal for the mortgage to the return.

  • $5,016.84 return + $1,408.84 increase in equity ownership = $6,425.68 in total return
  • $6,425.68 / $31,500 = 20% ROI

These ROI calculations are commonly used in real estate and can be helpful in getting a sense of the cash flows from an investment. However, they don’t tell the whole story since they don’t account for the complete gain or loss in asset value.

To get a more complete picture, investors need to also account for increases or decreases in the value of an investment property. It’s easier to do this in more liquid markets such as the stock market since you can follow daily price movements. However, with real estate, you can’t truly calculate ROI until you sell the property because the sale value of a specific investment property is not readily available. You’ll also need to factor in the many costs associated with a sale, such as appraisals, inspections, environmental reporting, title, insurance, recording, brokerage, and other associated fees.

Additional Considerations for Calculating ROI on an Investment Property

Neither of the examples above account for risk. If you are comparing two potential investment properties, and one has a projected ROI of 25 percent while another has a projected ROI of 30, you may think the latter is the superior investment. However, if that particular investment carries more risk due to factors such as property location, asset class, or age, it might not suit your tolerance for risk and fall outside your investment philosophies.

Additionally, neither example accounts for your planned investment holding time. A two-year investment offering a projected 10 percent ROI has a lower annual return than a one-year investment with a 10 percent ROI.

It’s important to note that calculating return on investment, while commonplace, is not a perfect science. Calculations can be subject to additional limitations, such as taxes, tenant turnover, or unforeseen capital expenditures. While not perfect, the formulas provided to calculate ROI can give investors a “best-guess” baseline of what to expect in a perfect scenario -- which, of course, rarely happens.

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. It should also not be construed as advice meeting the particular investment needs of any investor. Consult with your tax advisor regarding your individual circumstances.

 


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