calculating the return on
your investment property
your investment property
People invest for all kinds of reasons; whether you want to retire early, work part-time or save for an important life event, it’s important to calculate the return you’ll be getting on your investment property. We’ve included a basic guide on how to do this, so you’ll be on your way to achieving your investment goals quicker!
firstly, what is ‘return on investment’?
Return on investment (ROI) is a ratio between net profit (over a period) and cost of investment (resulting from an investment of some resources at a point in time). As a performance measure, ROI is used to evaluate the efficiency of an investment.
It’s important to keep in mind that while the formula seems easy enough to calculate, there are a number of variables to consider when it comes to real estate. Some of these variables include, but aren’t limited to:
- Management Fees
- Mortgage Repayments
- Vacancy Periods
- Council Rates
- Repairs / Maintenance
- Body Corporate Fees
- Accountant Fees
When calculating ROI, there can also be complications when your property is refinanced or a second mortgage is taken out. Interest on a refinanced or second loan may increase, and loan fees may be charged which can both reduce your ROI. Any new numbers need to be entered and the ROI recalculated in these cases.
calculating ROI – the cost method and the out-of-pocket method
There are two main methods when it comes to calculating ROI:
The Cost Method calculates ROI by dividing the equity in a property by that property’s costs. For example, a property is purchased for $400,000. The investor spends $50,000 on repairs and renovations to the property and the property is now valued at $500,000, making the investors’ equity position in the property $50,000. The ROI in this example is $50,000/$450,000 = 0.11 or 11%.
The Out-Of-Pocket Method is slightly different; the expenses are lowered meaning the ROI is higher. For example, using the same example from above, a property is purchased for $400,000, however, the purchase was financed with a loan and a deposit of $80,000. The investor spends $50,000 on repairs and renovations making the total expenses so far only $130,000. With the value of the property at $500,000, the equity position is now $370,000. The ROI in this example would be $370,000/$500,000 = 0.74 or 74%.
The huge difference is a result of the loan: leverage as a means of increasing ROI.
ROI doesn’t necessarily equal profit
Properties must be sold before either of the ROI’s in the examples above can be recognised as cash profits. The following factors also need to be considered:
• Your property may not sell at its market value. When the value is decreased, the ROI that was calculated for your property also decreases.
• Costs associated with selling your property – repairs, advertising, appraisal costs, commission etc.
While it is important to consider how the variables mentioned above impact you when calculating ROI, investing in real estate can be extremely rewarding if done correctly.
For income tax or capital gains tax, property owners should get professional tax advice from a reliable source before filing.
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