Return On Investment- The Ideal Way to Select The Right Investment Opportunity

  • Author: Shreshta Chillappagari
  • 5 min read
  • November 24, 2020
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The most significant motive of real estate investment is to increase your wealth over time. So, you invest in a property that tends to generate potential profits. If you can estimate profits before investing, you can make a smarter choice among the assets, by which you are likely to increase your ROI in Real Estate.

Making the right investment decisions is tough, and metrics like ROI have an essential role to play. If you have two assets at your discretion, how do you identify an efficient one?

One of the best indicators investors use to estimate the profits of different assets and compare the efficiency is ROI, Return On Investment. ROI indicates the amount of money that is regained through subsequent profits after deducting associated costs.

What is Return on Investment Analysis?

Answering this question correctly could significantly improve your real estate career. Real estate investing is built on a foundation of return on investment analysis. To get a return on your investment, you must invest and take risks. Real estate investing is all about earning a profit, making more than you invested, and knowing when to take risks. It should therefore be a no-brainer to perform a return on investment assessment. Let’s start with a definition and then go on to some measures specific to real estate.

To figure out the ROI of a given investment property, you’d perform a return on investment analysis. Using the return on investment (ROI), you can determine how efficient and profitable the property is. It’s the ratio of an investment’s return (profit) to the cost. You need to weigh the risks and rewards of a real estate investment before you can truly comprehend how to generate money from it. Analyzing real estate investments’ internal rate of return (IRR) can help you do this.

How to Calculate ROI in Real Estate?

ROI is the ratio of profits to costs.

Mathematically,

Calculate ROI in Real Estate

ROI measures the money or profit that you make on the Investment as a percentage of the cost. If you buy a property worth Rs.1,00,000 and sell it for Rs.1,50,000, your profit is Rs.50,000. The profit is half of your Investment, and hence your ROI would be 50%. Note that the example provided is for the understanding purpose and does not guarantee the ROI in any way. The ROI calculations using the formula containing associated costs are explained in detail in the further sections below.

Though the equation seems simple, it is indeed not. You also have to consider various variables like maintenance and repairs that increase with time; also, leverages that you borrowed to make the Investment. In turn, these variables affect the figures of your ROI, giving rise to different methods of calculating ROI.

Method Of ROI Calculation

  • Cost method

Cost method ROI is used in cash transactions, i.e., properties that are purchased fully with cash. It is a simple method of calculating ROI. You do not have to take into account the monthly interests on the mortgage as there are none.

Method of ROI Calculation

Net Operating Income is the overall income generated from a property. It is otherwise the difference between the income collected and the expenses.

Let us assume you purchased a property for Rs 1,00,000. You have incurred closing and maintenance costs of Rs.50,000. If you sell the property at Rs.2,00,000, then your ROI is as follows,

Latest method of ROI in Real Estate Calculation

  • Out-of-pocket method

The out of pocket method is preferred by real estate investors on mortgage-financed transactions. This method results in higher ROI figures and hence is widely used.

Let’s get back to the same example stated above. But, you have purchased the property with a mortgage. You have gone for a mortgage of Rs.70,000 and made a downpayment of Rs.30,000. You have also renovated the property and incurred a cost of Rs.50,000. This amounts to Rs. 80,000, which is the sum of downpayment and renovation costs incurred. It can be referred to as out-of-pocket expenses in cash. If your property’s value stands at Rs.2,00,000, then,

Out of Pocket Method in ROI

Note that the above ROIs are only for your understanding purpose and do not indicate the market’s current trends.

Importance of ROI in Real Estate

  • Represents the potential of the income-producing assets

ROI value shows the returns on the Investment. Higher the ROI, the greater the returns. A positive ROI indicates a profit, while a negative ROI represents losses. You must prioritize your assets with ROIs of bigger values.

  • You can compare the efficiencies of several investments.

Different properties have different ROIs. Depending on the factors like location and market value, the gains vary. Varying gains result in varying ROIs. Properties with higher ROIs tend to generate greater returns. You can hence compare the ROIs of different properties to decide which is an efficient one. It makes you an informed investor and helps you decide on the Investment when you have multiple options.

Limitations When Calculating ROI in Real Estate

The figures for ROI might be affected due to the following reasons

  • Assumption of occupancy for 12 months in case of rental property

While you calculate your ROI on a rental property, you assume that it is occupied for the whole year. You do not consider any vacancy that might occur. Vacancies reduce your gains, and hence you may end up overestimating the ROI.

  • Time is not considered while calculating ROI

When you see ROI as a performance measure to compare different properties’ efficiencies, the gains are only considered in evaluating the ROI. But, the period over which the profits are acquired is often neglected. The ROIs of multi-years have to be adjusted.

For example, consider a property with an ROI of 15% over a year and another property with an ROI of 36% over three years. The ROI of the second property is more than twice that of the first property. But, it has to be averaged before comparing them. So, divide the ROI of the second property with time, i.e.,

ROI for a year = 36/3 = 12%.

ROI for the second property is less than that of the first property over a year. Although you find that the second property may earn you more profits, it seems that the first property would be an efficient one.

  • Complicated calculation with variables.

You must consider associated costs like maintenance, mortgage, and repair costs that change with time. You find it difficult to calculate the ROI with variables.

The variables increase with time, which in turn increases your costs. Therefore, the ROI is reduced. If you do not include the variables, you are overestimating the ROI.

What Is Good ROI In Real Estate?

Return On Investment over the decade is following a skewed trend. RBI’s House Price Index shows that the average return from owning rental real estate over the last decade is around 11.6%.

If you purchase a rental property, see to it that its ROI should fall between 8-10%, and anything above 12% is considered a great one by the industry experts.

ROI on the commercial property should be in the range of 6-10%, which is slightly less than rental ROI.

According to a report by ANAROCK Capital, REITs outperformed BSE Realty Index at a whopping 14% ROI.

These are the current trends of ROIs of some real estate investments in the prevailing market conditions, which may vary with your location.

Calculating ROI makes you an informed investor by looking at the estimated returns from your Investment. The higher the ROI, the higher would be your gains. There are online ROI calculators that can ease your task of deciding on an efficient investment when you have discrete assets to choose from.

On a closing note, real estate never lets you down if you are a calculated investor. If you are a beginner, you can always approach numerous organizations and platforms that help you decide on your real estate investments. Assetmonk is an online platform that offers the best deals in the real estate field. It fetches the deals with ROI that is the best in the existing market.

ROI in Real Estate FAQ’s:

What is the ROI in Real Estate?

ROI means Return On Investment. It is the percentage of the returns that you have regained after deducting the associated costs.

Why is ROI important?

ROI is a performance measure that helps you compare the efficiencies of different properties and decide on your investment. It helps you estimate the profits on investment.

What are the types of ROIs?

There are two types of ROI calculations. The cost method is one of them and the Out-Of-Pocket method is another way of ROI calculation.

When is the cost method ROI is used?

The cost method is used to calculate ROI when full cash transactions happen.

Mathematically,

Method of ROI Calculation

What is the Out-Of-Pocket method?

The Out-Of-Pocket method is used to calculate ROI when you purchase the property with a mortgage. The interests must be considered while you calculate ROI. All the variables must be considered while calculating ROI and this method is complicated when compared to the cost method.

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