Return on investment is the ratio between the profits and costs of an investment. It measures how much money is made on investment as a percentage of the investment’s cost. Investors use ROI to evaluate profitability of an investment or to compare the profitability of different investments.  Return on investment (ROI) is a measurement of how much money or profit is made on an investment as a percentage of its cost. Since this metric shows how well your investment dollars are being used, it pays to know both what ROI is and how to calculate ROI in real estate.

HOW TO CALCULATE THE RETURN ON INVESTMENT

WHAT IS THE RETURN ON INVESTMENT?

The return on investment is determined by taking the difference between the gain from an investment and cost of an investment and dividing it by the cost of investment:

RETURN ON INVESTMENT FORMULA:

GAIN FROM INVESTMENT - COST OF INVESTMENT

__________________________________________  =    RETURN ON                                                                                             INVESTMENT                    COST (or VALUE) OF INVESTMENT

There are two methods for calculating ROI by using the above formula: the cost method and the out-of-pocket method. The  following are two examples of how the return on investment is calculated using each of these methods:

EXAMPLE 1 (COST METHOD)

If an investor purchases a property for $100,000, then spends an additional $50,000 on repairs and upgrades, after which the property value jumps to $200,000. The investors’ equity position in this case would be $50,000:

             $200,000 - ($100,000 + $50,000) = $50,000

             $200,000 - ($100,000 + $50,000) 

           ________________________________  =   .33, or 33%

                                 $150,000

Under this calculation, ROI would be .33%, calculated by dividing $50,000 by $150,000.

EXAMPLE 2 (OUT-OF-POCKET METHOD)

The out-of-pocket method, which is preferred by real estate investors because of higher ROI results, a loan for the down payment can contribute to better results. For example, the same property at the same purchase price, when financed with a down payment loan for $20,000 results in the following:

$20,000 out-of-pocket (loan for down payment) + $50,000 for

repairs = total out-of-pocket expenses of $70,000:

$200,000 - ($20,000 + $50,000) = $130,000

If the property is valued at $200,000, then the equity position is $130,000, placing the ROI:

     $200,000 - ($20,000 + $50,000)

   _______________________________  =  .65, or 65%

                        $200,000

This is nearly double the first calculation, as the loan increases the ROI.

HOW USEFUL IS THE RETURN ON INVESTMENT?

Calculating the ROI is an essential step for determining whether your investment property is likely to turn a profit now and in the future. These formulas will help you arrive at that figure to better illustrate the investment potential.  The formula can also illustrate whether an investor should decide to finance a property and how much down payment is required in order to achieve a certain figure.  This becomes important in value-add deals where the ROI can change significantly, as described above, by appreciated the value of a property through repairs or remodeling of a recently required commercial property.