In any investment opportunity, the one question behind it is always: How much will the Return on Investment (ROI) be?
Let’s face it, profits drive investments. The higher the ROI, the higher the return on investment.
Generally, every real estate investor spends money on what they can profit from. And if you consult experts in the industry, they’ll all tell you the same thing – A good investment requires a thorough analysis.
This helps you to compute how much you can expect from your investment. Basically, it gives you a realistic outlook of your ROI. With this knowledge, it becomes easy to determine whether or not it’s a good investment.
Now, when it comes to real estate, determining what is and what’s not a good return on investment can be a bit tricky. That’s because not all investors view ROIs equally. Sometimes, a good ROI in one investor’s eyes can be a bad one in another’s.
Let’s look at this example: Most investors would argue that a 10% annual ROI is good. But some often feel like anything less of 25% per annum is not worth investing in.
Therefore, a “good return on real estate investment” greatly depends on how you look at it. Which brings us to the question. What is a good ROI in real estate investment?
To get a clear answer to this question, you must first learn how to measure returns. That way you’ll know how much to expect from your investment.
4 Simple Methods of Measuring ROI in Real Estate
Once you know how to measure the return on a real estate investment, it will be easier for you to determine whether or not it’s good. Here are four sure methods that you can use:
1. Return on Investment (ROI)
Arguably, when calculating the profitability and efficiency of a real estate investment, the ROI is often a vital factor to consider. Now, there’s no straight answer as to whether or not an investment is good or not. That’s because there are other factors that come into play.
These are some factors that you will need to consider:
- The location and size of the property
- The risks
- Your investment objectives
Generally, a lower ROI (5% – 15%) in a safe and growing neighborhood can be deemed as good. But riskier investments need to have a high ROI (20% – 40%) in order to qualify as worthy.
To get a better understanding, here’s a real example:
If you buy an investment property for $400,000 and end up collecting a rental income of $30,000 annually, your ROI can be calculated as:
ROI = Annual Rental Income/Total Cost of Investment = $30,000/$400,000 = 7.5%
Now, some investors may be okay with this figure while others may see it as too low to bother with.
2. The 1% Rule
This rule states that the monthly rent should be more or equal to one percent of the cost of investment. Basically, if you buy the property for $400,000, you should charge at least $4,000 in rent every month. If that’s impossible, then the investment may not be that lucrative.
But if you calculate its ROI ($4,000 X 12 = $48,000 / $400,000 = 12%), you’ll notice that it’s within an acceptable range. Therefore, this makes it a good return on real estate investment.
3. Cash on Cash (CoC) Return
Another great way to determine the worthiness of an investment opportunity is through a CoC analysis. The CoC return helps to measure your annual return on investment based on the Net Operating Income (NOI) and Total Cost of Investment.
You should note that CoC returns vary depending on the financing method used. Therefore, it’s also not clear in terms of “what a good return on investment is.”
For a better understanding, let’s use a real example:
So, you buy a rental property using a loan of $400,000 with a down payment of about $100,000 (25%). Thereafter, you start collecting $3,500 as rent each month. At the end of the year, you make about $38,000 (minus $4,000 in operating expenses). Your CoC would be:
CoC = Net Operating Income / Total Cash Investment = $38,000/$100,000 = 38%
Now, if you paid for the property using your own cash instead of a loan, your CoC would be:
CoC = Net Operating Income / Total Cash Investment = $38,000/$400,000 = 9.5%
Most experts will argue that a good CoC ranges from 8% to 12%.
4. Capitalization Rate
In the property market, a capitalization rate is simply a ratio of the property’s NOI to its initial investment price. And just like the ROI, the capitalization rates also depend on a few determining factors like the risks, location, and size of the rental property.
Therefore, it wouldn’t be easy to tell whether an investment is good or not. Now, to calculate a property’s cap rate, here’s the formula:
Cap rate = NOI / Total cost of investment.
Therefore, if you buy a property for $400,000 and manage to make $25,000 as the Net Operating Income, your cap rate would be:
Cap rate = $25,000 / $400,000 = 6.25%
Now whether or not 6.25% is a good return on investment greatly depends on the determining factors mentioned above.
In summary, the answer to the question of what is a good return on real estate investment looks like is never straightforward. There are other critical factors you may have to consider.
Generally, these are factors that directly or indirectly affect your investment. But, at the end of the day, a good investment will be dependent on your preferences and goals.