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.