Today I’m going to talk about how to calculate return on investment for real estate. There’s two different approaches that people use.
Return on Investment
-Equity Position divided by costs of buying real estate (including repairs)
-ROI based on equity in the property
Out of Pocket Approach
-Use as a real estate investor
-Equity Position divided by personal investment in the property (doesn’t include bank’s contribution)
-Gives you a much higher ROI!
The first one is what I call the cost approach. Let’s say we bought a property for $80,000 and we put in $20,000 for repairs, making it worth $140,000 after it’s fixed up. We’re all in for $100,000 with an after repair value of $140,000, giving us an equity position of $40,000.
The cost approach will take the equity position and divide it by all the costs associated with buying that piece of real estate- in this example that would be 40 divided by 100, giving you a 40% ROI. Remember, this is a return on investment in regards to the equity on that property.
Real Estate Investor Approach
The approach that we use as real estate investors is the out of pocket approach. Now you may have spent $100,000 acquiring a property but you probably took out a loan. So let’s say you took out a loan with a $10,000 down payment- your out of pocket investment is really only $10,000. So now you take your equity ($40,000) divided by 10 instead of 100- giving you a 400% return on investment. That’s an important difference!
As investors we like to use the out of pocket approach, because it’s the return on the money we’re investing into the deal.
A lot of people- especially those that are accounted minded and like to analyze and crunch numbers are stuck on the cost approach. The problem with that is that it’s not truly what’s happening to your money. In the cost approach you’re calculating the entire cost of the deal including the bank’s contribution, but then you’re using leverage to get a much higher return on that.
The methods I’ve shown you calculate ROI based on equity- $40,000 in this particular deal. Remember that that’s not cash you can go out and spend, because you’d have to sell the property to access it. I
If you sold it immediately you’d have to pay some transaction costs and it would go down a little bit. But if you kept it, over time that equity would grow as the house appreciated and you could get a loan based on that equity because it contributes to your net worth. Now a bank will loan to you based on this $40,000 increase to your net worth. You also have to consider the impact of time on your money- while in this example you have a 400% ROI, you may only get 100% a year if you hold onto it for four. I know “only 100% return” sounds strange, but in real estate you can get these kinds of returns- that’s why people become wealthy really quickly.
So that’s how to break down return on investment. We use the out of pocket approach when dealing with real estate. If you have any questions feel free to comment, and I’ll make sure to answer anything I get.
Today we’re going to take the concept of calculating return on investment a step further. Last week we determined ROI based on the equity position of your real estate. But the cool thing about this investment is that there’s more than one way you can make money.
Balance Sheets and Income Statements
-Balance Sheets: The equity in a house or the net worth of a human
-Income Statements: The cash flow of a property or the income of a person
-Your property’s equity is added to your net worth, and its cash flow is added to your income
Return on Investment
-First calculate your ROI based on the equity in the property
-Your yearly cash flow divided by your initial investment will give you your ROI based on cash flow
-Add these together for your total ROI
Individuals vs. Properties
If you’ve read “Rich Dad, Poor Dad” by Robert Kiyosaki you’ll remember that he encourages everyone to get familiar with two different types of financial statements.
The first financial statement is your balance sheet and the second is your income statement. Most people don’t know the difference between these two. The neat thing about financial statements is that while individuals have incomes and balance sheets, so do pieces of property. A house’s balance sheet has to do with equity, but a human being’s balance sheet has to do with their net worth. A house’s income statement would have to do with the cash flow of that property, while the income statement of a human would relate to the income from their job.
Personal Balance Sheets
The moment you purchase a piece of real estate and rehab it, the financial statements of the property attach themselves to your personal financial statement. So if you’re buying a house with $20,000 in equity, you immediately bump your net worth by $20,000. If you have a cash flow of $2-300 a month on a property, your personal income immediately increases by $2-300 a month.
But just as a property can positively affect your personal income and balance sheet, it can also negatively impact it. So if you buy a house that has negative equity or is upside down you can negatively affect your net worth. The same thing happens if you buy a house that has negative cash flow- you’ll negatively affect your income statement. So be aware of this trend as well. You must buy real estate correctly in order to get it to do these things.
On the balance sheet of a piece of real estate you may have $10,000 invested, but the equity in the property is $20,000. So you have a 200% return on your balance sheet. However, that house might also cash flow $200 a month. If you multiply that by 12 months it’s $2,400 a year. And with your $10,000 invested that’s a 24% return on investment based on cash flow.
So there’s two different ways to calculate return on investment. This confuses some people because one person will say “I got a 200% return on my real estate deal,” but the next person will say they only got a 24% return. You may think the first one was a much better deal, but you have to be aware of what they’re talking about. Are they talking about the balance sheet or the income statement?
Add it Up!
The cool thing is that if you have both of these things you can add them together for your entire return on investment. I haven’t even mentioned the four other ways you can make money with real estate- tax advantage, principle pay down, etc., which would make these numbers even higher.
So today I just wanted to get you familiar with the income statement and the balance sheet- two different ways of calculating return on investment. Also remember that when you buy a piece of real estate it attaches to your own.