While real estate investing can be exciting and personally rewarding, it’s not something people do for fun. The primary purpose of investing is to build wealth. And you do this by generating a return on your investment, also known as ROI.
But what does that really look like? In other words, how do you determine ROI and optimize for it? If you’re asking questions like these, you’re on the right track. And in this article, we’re going to provide you with some clear cut answers so that you can become a more successful Houston real estate investor.
What is ROI?
As Investopedia explains, “Return on investment measures how much money or profit is made on an investment as a percentage of the cost of that investment. It shows how effectively and efficiently investment dollars are being used to generate profits. Knowing ROI allows investors to assess whether putting money into a particular investment is a wise choice or not.”
ROI is a metric used for tracking any sort of investment, including stocks and bonds, retirement accounts, mutual funds, and even precious metals or collectables. In essence, you can track an ROI on any item or asset that was purchased at a specific price and currently has a monetizable value.
How Do You Calculate ROI?
It’s fairly easy to calculate the ROI on a stock. You take the current value of the stock price and divide it by the price you paid. That gives you the return.
For example, if you paid $55 last year for a single stock in ABC Company and that stock is worth $60 one year later, you would compute the following:
(60) / (55) = 1.09
That means you’ve gained 9 percent on your investment. Thus, your ROI is 9 percent.
But let’s say you purchased the stock for $55 last year and it’s now worth just $40. You would perform the same type of equation:
(40) / (55) = 0.72
Because this number is less than one, it indicates there’s a negative ROI. Subtract the difference and you get .28, or 28 percent. This indicates you have a rate of return of -28 percent.
Those are pretty simple computations. But things get a bit more complicated when it comes to real estate. In fact, calculating a meaningful ROI figure on residential property can be difficult. Nevertheless, here’s what the equation looks like:
ROI = (Current Value of Investment – Cost of Investment) / (Cost of Investment)
In other words, if you bought a house for $100,000 and it’s now worth $120,000, you would run the numbers like this:
($120,000 – $100,000) / ($100,000) = 20 percent
The equation above is pretty simple, but it gets more challenging when you look at rental properties (which is presumably what you’re interested in learning about).
Let’s say, for example, that you paid $100,000 in cash for a Houston rental property. You then paid another $10,000 in remodeling costs and closing fees. This brings your grand total to $110,000.
Every month, you collected $1,000 in rent. Which means one year later, you’d collected $12,000. Expenses (water, electricity, gas, etc.) totalled $2,400 for the year. This leaves you with a gross annual return of $9,600.
Run the numbers and here’s what you get:
($9,600) / ($110,000) = 0.087
Your ROI is 8.7 percent for the year.
But what about financed transactions? Things get even more complex when you throw a mortgage and interest rates into the mix. Using the same $100,000 rental property example as above, let’s say you put down $20,000 in cash and financed the rest of it. You paid $2,500 in closing costs and another $9,000 in remodeling for total out of pocket expenses of $31,500.
Now here’s where you have to be diligent and accurate. Let’s say the 30-year loan came with a 4 percent interest rate on the borrowed amount. This makes your monthly payment (principle and interest) roughly $381.93. Add in the same $200 in monthly expenses and your outlay is $581.93.
Rental income is the same as above, meaning you pull in $1,000 per month for a total inflow of $12,000 on the year. This makes your monthly cash flow $418.07 ($1,000 – $581.93). Multiply this by 12 and you get a total annual return of $5,016.84.
At first glance, you assume that paying in cash was the better move. After all, you had an annual return of $9,600. But that’s not the case. Consider the ROI on the financed property:
($5,016.84) / ($31,500) = 0.0159.
That’s a 15.9 percent return – nearly double the 8.7 percent from above!
The reason is that you put down just 20 percent of the cash that you did in the first illustration. So, while you’re technically bringing in less per month, your money is working harder for you.
Tips for Increasing ROI
Is your head spinning from numbers? Let’s make it simple with a few tips and general rules of thumb for increasing ROI on rental properties:
- Minimize your down payment. If interest rates are low – which they are right now – you should absolutely minimize your down payment to a point that makes the most sense. This automatically drives up your ROI.
- Keep the property rented out. It doesn’t matter how low your interest rate is or how clever you are with financing, you can’t generate a robust ROI without having the property occupied and rented as much as possible. Make this the focus!
- Increase rent, decrease expenses. Over time, the goal is to raise your rents (within legal limits) and decrease expenditures. This produces greater monthly cash flow, which elevates your annualized ROI.
Green Residential: Houston Property Management
At Green Residential, we believe in helping Houston real estate investors and landlords optimize ROI through strategic property management services that maximize the upside while protecting the downside. For more information, please contact us today!