Posted: Thursday 4th October 2018
Investing is a tempting process as it can be extremely rewarding and profitable but at the same time is complex and requires thorough research, preparation, and calculation. Although there are different types of investments, we will be looking into property investment as real estate is overall a great choice to put your money in and receive long-term benefits after. Real estate investing has a high chance of providing an ongoing positive income for the investor as its value usually increases over time. It is a common strategy for experienced investors to spread their investments across different types of property in order to maximise wealth.
When making a decision on whether to invest in something or not, there are a number of factors to consider. Whether you are a beginner in investing or you have years of experience behind your back, the first thing to begin with then reviewing a potential investment is the ROI – Return on Investment.
Return on Investment, often referred to as ROI for short, is defined by Investopedia as a “performance measure, used to evaluate the efficiency of an investment or compare the efficiency of a number of different investments. ROI measures the amount of return on an investment, relative to the investment’s cost.”
In simple terms, ROI is a metric that helps investors understand whether their investment has been successful, as it measures how much money is made from investing as a percentage of the cost of the investment. It is purely used to establish how much money your invested capital is making you. So, for every pound spent, how much pounds have you gained? This is, purely, the way that ROI works.
Return on investment is not the same for all types of investments and is likely to undergo constant changes due to external factors influencing the investment. The different types of industries to invest in will also have their own, specific set of factors that must be considered in the ROIs equation in order to calculate the returns as close as possible to reality. The bottom line is that if you have decided to make an investment it will not be possible to establish its profitability without calculating its ROI first.
ROI will give investors the profit of an investment in percentage terms as it is a profitability ratio. To calculate standard Return on Investment, the original cost of the investment is subtracted from the total return on the investment. To get your answer in percentage, the profit made on the investment is divided by the cost of the investment.
To sum up from the description above, ROI is calculated by using this simple formula:
The original state of this equation seems like no burden as it is simple enough for non-accountants to understand and be able to use. However, when dealing with property investment and the calculation of property ROI, things might be a bit more complicated, due to the additional factors that must be considered.
For example, there are likely to be repair or maintenance costs associated with the investment. Different tactics used for leverage play a role in the calculation. How much from the investment will be borrowed and how much is your own? The different types of financing can also influence the price of investment. In such cases, investors or accounts usually use a mortgage calculator for finding the best interest rates out there, therefore reducing the cost of the investment and increasing the chances of a higher ROI.
There are two common methods used for calculating ROI with property investments:
This method finds out what the ROI of investing is by dividing the equity in the property by all the costs, including repairs, maintenance or costs required for the purchase of the property.
This method usually provides a higher ROI for investors and therefore is preferred by many. This method incorporates a loan or down payment amount into the equation. For example, if a property is worth £100,000 with a loan of £20,000 and other repair expenses of £50,000, the total out-of-pocket expenditure related to the investment is £70,000. Say the value of the property is £200,000, the equity position becomes £130,000, considering the cost of the property – £100,000. When calculating ROI in this scenario, the equation would look like:
£130,000 ÷ £200,000 = 0.65 or 65% ROI
It should be noted that ROI may not always be as high in reality as calculated by the equation. The main reason is that when dealing with property, the ROI cannot be realised if the property is not sold. However, keep in mind that property is not always sold at its original market value and there are often costs associated with making the sale, which are all factors that will negatively influence the original ROI calculations. Any expenses related to promoting the property on the market or working with a professional agency, requiring commission, are also influencers.
As it turns out, calculating ROI on property is not as simple as it looked from the beginning. However, property remains one of the strongest investment methods across the majority of the world, with the some of the highest ROI numbers that can be achieved.
There are different types of property that investors can expect to get a return on. The different types of property would include a diverse set of factors influencing ROI and therefore would require alternative calculating methods.
Often, investors purchase property with the idea of renting it out to tenants in order to maximise the wealth gained from it in the long term. The profitability of such an investment is dependent on the initial cost of the property and the rate of return. With the popular trend of individuals and families renting real estate around the world, the ROI is high with this type of investment.
Calculating rental property ROI starts with calculating the annual rental income and subtracting the expenses to get the cash flow of the property. Once you have your cash flow, add the equity build to receive the net income. Finally, the net income is divided by the total investment required, which gives you the ROI on the investment.
When deciding on the type of rental property to invest in, a single family and multifamily option should be reviewed and calculated in terms of future profitability. A look at the external factors such as the area the property is located in, average income trends in the area and population trends should also be examined.
In the UK, for example, renting out property room-by-room is a popular practice that gives a different outlook on ROI. With rental property, another key metric is considered – the yield. This is another form of establishing profitability of a property investment but in the long term, including the rental amount and excluding capital gains.
The yield considers a specific time period when calculated, assuming the rent cost remains the same. Research from the UK in 2017 shows that a room-by-room renting out strategy, or HMO, gives landlords an average yield of 8.9%, compared to a 5.6% on “vanilla” buy-to-lets, where the whole property is rented out under one agreement. Multi-unit rentals, such as blocks of flats, brought an average of 8.1% return in 2017.
The simplest form of making money from investing is buying low and selling high. This is the bottom-line nature of a fix and flip type of property investment. In establishing the ROI in this case it is important to consider a few factors:
Typically, the average Return on Investment with the Fix and Flip method is around 10% due to the expenses.
Some of the main factors that influence ROI with commercial property are operational or other forms of expenses, demand and property valuation, occupancy rates and income, location, and others. With commercial property, it is essential to have an understanding of the future of the property in order to make the most realistic judgement of the expected ROI. According to statistics, the average 10-year returns in commercial real estate are calculated at around 6.1%, in comparison to the 7.5% calculated with residential property, meaning that the returns are slightly lower with this form of investment.
Deciding on the profitability of property investment is all about making the right calculations and planning well. Although Return on Investment is a major metric to be considered in the decision-making process, it is certainly not the only one.
When beginning to look at a potential property investment, assess what the pre-tax cash flow of the property is. Think about what the gross rental income will be if you are indulging in rental property. Research the local area, check for similar property and how its rent has moved throughout the years to get an understanding of what your property may experience in the long-run. Are there any factors that may bring the rental price us, such as proximity to important institutions, bus stops, etc.? What are the running costs? These include property management fees, maintenance costs, landlord insurance, any council taxes or utility fees associated with the property. What will the financing costs e?
Once you have this information, you can calculate the net cash flow, along with the real gross yield on your investment, two important metrics that provide a realistic outlook of the profit-making potential of your investment.
Investing in real estate is a popular and profitable form of investing, widely spread across the world. High rental yields are tempting for investors and the fact that they are easily calculated give investors the confidence in exploring the option of property investing. Buy-to-let properties often appreciate in value with inflation, resulting in a potential equity line of credit that can be invested elsewhere, for investors looking to expand their portfolio. With property, it is also easy to increase the value with renovation of maintenance of the property, bringing up the future cost of the property and getting higher returns. Property is also one of the most stable assets to have. Fluctuations in value are, of course, evident based on a wide range of factors, but can be predicted and followed with analysis and forecasts.
There is a high level of guarantee that you will not be making losses with property investment. Furthermore, the sophistication of control on property investment is high. There is a range of property growing options that investors can explore, making this form of investment attractive. If you are a beginner in property investment it may be worth contacting a specialist or a property investment consultant that can help you understand the market better, explore in detail your available options and guide you through the process. Your consultant will also be able to help out with vital calculations that will shed light on your investment and avoid any risk-taking. After all, predicting the return on investment is one of the key factors influencing an investor’s decision and is a step that should not be overlooked.