Return on Investment (ROI)
The ROIal metric you need to know before you invest.
- Return on Investment metric definition
- Reasons why ROI is crucial to understand
- Types of ROI in practical use
- “Good” vs. “bad” ROI misconception
- ROI calculation formula
- SWORP TIP!
One of the first numbers every investor should be familiar with when deciding if the property he considers will be profitable, is its annual ROI (Return on Investment). For most investors, it is the decisive figure to measure investment success over a specified period of time. Also, ROI indicates how risky the investment you consider would be, because the higher the potential return, the higher level of risk. It’s expressed as a percentage of the cost of the investment.
We recognize two types of ROI: Gross Return (nominal interest) and Net Return (effective interest). Both are calculated differently and both are used for different evaluations of investment. Gross ROI counts with total collected rent per month x 12, that is annual rent, and total purchase costs of the property (including purchase price, remodel costs, agency fee - if applicable -, and closing costs). Net ROI also counts with total purchase costs of property, but in this case, annual net rent is used in calculations. Annual net rent is annual rent after subtracting costs of annual maintenance, property tax, insurance, cumulative interest paid, and property management cost - if applicable -. Obviously, the net ROI of a property is always lower than the gross ROI.
In the property business specifically, the percentage of gross ROI tells you how much profit you can expect to make in rental income over the long term and it is useful when comparing properties you consider as future investments. On the flip side, net ROI tells you how well your rental property performs over a certain period. You can have two investment properties with identical gross ROI, but very different net ROI, if one of the properties has high annual expenses due to the planned installation of an elevator or major facade repairs. Therefore, it is not a good idea to base your investment decisions on a gross ROI comparison of properties.
There isn’t anything like “good” and “bad” ROI for rental property. It always depends on the type of property, location, how much you charge in rent, as well as your financing method to purchase the rental property (cash or mortgage). You also need to determine the goal for your rental business. In general, however, most investors aim for the investment’s gross ROI to be at or above 10%.
Among many factors that cause an increase or decrease in the ROI, the most important include occupancy rate, rental income, purchase price, reconstruction costs, maintenance, insurance, property taxes, monthly loan payment, and down payment for a mortgage. In the end, two very similar properties located in the same city may generate a very different ROI. In general, the higher the ROI the more profit the property potentially offers.
However, even if not necessarily as a rule, with higher ROI, you should count with higher risk potential. Also, a mortgage increases the ROI significantly, so you should always consider what your goal is. Do you want to simply buy and then sell quickly? Do you want to harvest rents for a long time? Your strategy should meet your expectations and what are your plans with the property.
Now let’s have a look at real data. To define the net ROI of your property, you need to evaluate quite an amount of numbers related to the property. However, be sure it’s worth it because you’ll get one big step closer to establishing yourself as a confident and savvy investor.
Net ROI calculation in a nutshell:
Not that complicated, right? This is how you know how much of the investment you retrieve from the property annually.
A tiny bitty Alas:
To calculate the annual net return, you need a few more numbers. Let’s check with us:
- Rental income for 12 months
- Annual insurance cost
- Annual property tax
- Annual general expenses
- Real Estate renting fee and advertising cost (if applicable)
Total investment is NOT the purchase price you paid for the property. Let’s check with us:
- Property purchase price
- Real Estate agency fee
- Other costs ( mortgage associated, transport, translations, etc.)
- Cadastre registration
- Real Estate Transfer Tax (4%, if applicable)
- Reconstruction and remodeling costs (repairs, furnishing)
Now the math is easy.
Is it 5%? Your property will return your investment in 20 years. Is it 50%? Your investment will return in 2 years. Remember, a higher ROI number isn’t necessarily better. Always include your intentions into the equation.