How do you understand how profitable this or that investment in square meters is for you? What is the formula for calculating ROI? What other indicators should an investor take into account? The answers to these questions are in the material of the American financial publication Bankrate; We have prepared a translation for our readers.
When you consider buying a property as an investment, it is important to have an idea of how much you can earn from it. The indicator that measures this is called ROI – “return on investment”, or return on investment.
The return on investment can be calculated for the entire period of ownership, when your property generates income, and when selling, when you receive a capital gain or loss.
How to calculate the return on investment?
Return on investment = (operating income + sale price of investments – acquisition cost) / acquisition cost.
“Return on investment is a measure of how much you’ve earned on the money you’ve invested,” says Greg McBride, chief financial analyst at Bankrate. “You have to account for all your expenses: the down payment on the loan, loan payments, closing costs, property taxes, property insurance costs, maintenance and repairs.”
One of the most common ways to make money by investing in square footage is to wait for your property to rise in price over time. For example, you buy a house for 300 thousand dollars, and within five years its market value increases to 400 thousand dollars. This means that it has increased in price by 100 thousand dollars. Let’s say that in addition to the $300,000 you bought the house for, you also spent $40,000 on repairs and earned $20,000 on rent, and now you’re selling it for $400,000. Following the formula above, $20,000 (operating income) plus $400,000 (selling price) minus $340 thousand (cost) is $80,000; $80,000 divided by $340 thousand is equal to 0.235, so your ROI is 23.5%.
Calculation of ROI for various investment strategies
Resale. Subtract the total cost of the investment from the final sale price, then divide this number by the number of investment costs. The result of this mathematical operation will be the return on investment.
Rent. Renting out housing can bring stable long-term income. Determining ROI in this case requires a preliminary calculation of your projected annual rental income and your annual operating costs, which may include things like insurance, property taxes, HOA contributions, and maintenance costs. Then we use the formula: return on investment = (annual rental income – annual operating costs) / the cost of a mortgage loan (that is, the amount that still needs to be paid on a mortgage loan).
Real Estate Investment Funds (REITs). This passive approach to investing in real estate does not involve an individual calculation, but the purchase of REIT shares and the receipt of dividends.
Other ways to evaluate the profitability of investments
The potential return on investment can be estimated in several ways, and it is not unusual for investors to combine several indicators to create a more complete picture.
The capitalization rate. This is an indicator of the annual return on renting out real estate, excluding debts. The formula includes three variables – net operating income, real estate value and rate of return – any of which can be calculated using the other two.
IRR is the Internal rate of return, or the internal rate of return. The IRR measures the annual rate of return over a period of time, not the total time of ownership.
Cash yield. This simple formula compares the annual cash flow from real estate before taxes with the total amount of money invested. Cash settlements usually measure returns over a very specific period of time, such as one year.
Factors that can affect the return on investment in real estate
Potential profit, or ROI, can be influenced by various external circumstances.
One of the most important is the general market situation. For example, limited supply usually leads to an increase in the value of real estate on the market. This situation can significantly increase the return on investment.
The cost of buying a house also affects the profit that investors can make when they are ready to sell it. The more you have paid for the property, the less money you will have in your pocket in the end – unless the cost has increased significantly.
Mortgage rates can also affect profits when selling a home. When interest rates are high or tend to rise, house prices are often adjusted to attract cautious buyers (although this is not the case in today’s market). A lower price means less profit from the sale.
Location is another factor that can increase or decrease the return on investment in real estate. For example, a house located near a highway is likely to cost less than a house near a park or beach. Location, including characteristics such as the attractiveness of the area, safety, proximity to schools, entertainment, medical centers, public transport stops, can affect the return on investment.
The cost of materials needed for construction or finishing is another factor affecting the return on investment. If such goods are expensive, this will increase the amount of investments and, ultimately, reduce the profit earned from the sale of real estate.
What kind of real estate is worth investing in?
There are many different types of residential real estate that are worth investing in: individual houses, townhouses, apartments in residential complexes and apartment buildings, land plots. The choice depends on the goals and capabilities of a particular investor.
What is a good return on investment in real estate?
The return on investment is variable and depends on many factors – there is no universal answer to the question of what is considered a “good” return. According to the S&P 500 index, the average annual return on investment in residential real estate in the United States is 10.6%, so anything above this figure can be considered above average. The return on investment in commercial real estate is on average slightly lower – 9.5%, while in funds it is on average slightly higher – 11.3%. The return on investment can also vary depending on the type of object, therefore it may be different for an apartment building than for an individual house.
What steps should a person take to become a real estate investor?
First, think about what kind of investor you want to be. Are you ready for active actions, for example, to repair objects and sell them? Or do you prefer a more passive approach, such as investing in REITs (real estate investment funds)?
Additional steps to get started include analyzing the market in which you plan to make investments and studying local real estate laws.
Source: Bankrate
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