Investment in property differs from other options in the current market. The initial capital cost is higher, it has more regulations policing its transactions, and it tends to have a longer lifespan compared to your traditional investment.
However, it still bears some similarities to other investment and business vehicles. When considering a new investment, an investor’s key concern would be whether they can be able to make a profit. If not, they’d consider a different approach altogether.
How is the comparison made? You make use of a financial metric known as the return on investment (ROI). In this article, we will be breaking down what is ROI and also help prospective investors reading this know how to calculate it.
What is ROI, Return on Investment?
This is a financial measure that helps investors and other key stakeholders estimate how profitable an investment is. The return on investment is essential to know the opportunity cost of sacrificing your funds for one investment over another.
You should be aware that the ROI is not a metric that is unique to the property industry. You might have heard of it in other circles. It’s possible to calculate the ROI for financial bonds, stocks, cryptocurrency, and more.
The calculation of ROI for a rental investment can be a bit complex due to the extra subtractions that you will have to make to arrive at the correct figure. However, do not worry. We will unpack all the components below in an easy-to-understand manner.
Calculating the ROI
You’ll need to gather property details from the subject investment to be able to calculate the ROI.
First, you might need typical property details such as the square footage, the amenities offered, and the number of bedrooms and bathrooms. This will be important later on when you do the comparison of the properties.
You’ll require the rental income and expense details. A property might have several income avenues apart from the rental income. This might include parking, vending, and renting out storage spaces. Some of the typical expenses are regular maintenance costs, HOA fees, and property management fees.
If you’re planning to acquire the property using a mortgage, you’ll have to know what the monthly repayment costs are. It might also be a good idea to look at the entire mortgage packet and know the finer details like the interest rate and down payment and calculating taxes.
Ownership and leasing of property require you to have permits and licenses. These are usually one-time annual costs.
The above information will allow you to calculate the following:
- Gross Annual Income. This is the total income derived from the multiple income streams from the investment property
- Net Operating Income. Also known as the NOI, this is calculated by subtracting the total property expenses from the Gross Annual Income.
- Annual Cash Flow. Though not a must, you can be able to calculate the annual cash flow from the investment property. It represents the cash profit or loss you generate annually after all costs (including the mortgage costs) have been paid for.
With all the necessary components calculated, you should now be able to calculate the ROI for your desired property.
Return on investment (ROI)
= Profit (Sale price –Cost of the investment)/ Cost of the investment.
In most circumstances, the ROI is provided as a percentage. Therefore, the figure that you get from the above formula should be multiplied by 100 to arrive at the final metric.
Let’s say that you were able to purchase a property for $500,000 in your typical residential neighborhood. The area experiences a boom in demand for housing due to an announcement made for the renovation of infrastructure and road works. You perform renovations to the property worth $50,000.
At the end of the year, you are able to sell the same property for $900,000. As per the above formula, the profit will be $900,000 minus $550,000, giving you $350,000.
Return on Investment
= $350,000/ $550,000 *100 = 63.64%.
From our experience in the property market, any figure you get above 10% is a favorable figure. Most property investors gauge any ROI between 5 and 10% to be a viable investment.
As you perform these calculations, you must remember that the needs, the capacity for risk, and also the financial capability of each investor are different. You know what you can afford while meeting other financial obligations.
Analyze the best option among the different options and make a decision you are most comfortable with.
The Importance of the ROI Metric
The ROI is important when you have several investment options to choose from. You’ll gather the necessary information i.e. the income, costs, and other expenses to derive the ROI. Choose the property with the highest ROI.
If you’re relying on financing from a mortgage company, some might request for you to provide additional information to support the purchase of the rental property. This will give the lending company faith in your choice of property.
Now you can calculate the ROI for your potential investment in South Bay real estate! You can also appreciate the amount of technical expertise and knowledge you need to make a profitable investment. Do you feel a little out of your depth? You might need the expertise of an experienced property professional in the industry.
Pinnacle Property Management is the company to rely on with over three decades of property experience in the South Bay area. We’re the service providers that property investors rely on for sound and professional advice. We offer our services across the South Bay region, including Redondo Beach, Harbor City, Manhattan Beach, El Segundo, Long Beach, Hawthorne, and more.
Get in touch with us today. Our dedicated staff is looking forward to hearing from you. You’ll receive a free quote for all your troubles.