How to Calculate ROI for a Potential Real Estate Investment
Summary: For the commercial real estate investor, few things are more important than ROI. Being able to accurately calculate the potential profits from an investment property before acquiring it is crucial to gauging and increasing the chance of a successful investment. This is where calculating ROI comes into play.
How to Calculate ROI for a Potential Real Estate Investment
Real estate private equity is beloved by investors seeking refuge from the volatility of public equities. For the real estate investor, few things are more important than ROI (return on investment). Being able to accurately calculate the potential profits from an investment property before acquiring it is crucial to gauging and increasing the chance of a successful investment. This is where calculating ROI comes into play.
ROI is a comparative metric that accounts for the ratio between the profits and cost of an investment. In the case of real estate private equity, ROI is critical because it represents the potential of income-producing assets. A higher ROI implies that the profits you’ll receive from an investment property compare favorably to its cost. As an investor, this metric is crucial when comparing several different investment opportunities.
So now that we understand the importance of ROI, how is it calculated? The formula is quite simple:
ROI= (Proceeds from Investment – Cost of Investment)/Cost of Investment
- Calculate the expected annual rental income
- Subtract rental expenses from annual rental income
- Compute your % share of the net income
- Divide your net income by your total investment
While being able to calculate ROI is important, knowing which variables affect these data points is crucial. You need to know what key factors to look for in a real estate investment to ensure you make the right investment choice and earn a favorable ROI.
One of the main benefits of investing in real estate is the potential for immediate income: tenant rental payments. If a property you are considering investing in comes with tenants already in place, you will want to consider a few variables in their leases before determining if it is a suitable investment:
1) The amount of time left in a tenant’s lease – Is their lease about to run out? If so, what is the likelihood they will renew?
2) The financial security of the tenant – Are they credit worthy? Will they stay in business?
3) The amount of space a tenant occupies relative to the total building size – How much risk are you taking on if that tenant were to leave?
On the flip side, owning an investment property comes with costs. Common expenses include utilities, maintenance, property taxes, and insurance. If you are investing in commercial buildings, you will likely have to pay to hire a full-time property manager to handle the day-to-day work and manage relationships with the tenants. These costs can add up quickly, so it’s essential to have a thorough understanding of a property’s operating expenses and how they compare to your total rental income.
Another common reason investors flock to real estate is its potential for appreciation over time. Successful real estate investments are largely dependent on timing and location. When considering an investment, key indicators such as year-over-year job growth, population growth, economic growth and industry diversity have historically been important factors driving the increase (or decrease) in property value over time. It is also worth noting that trends point to the millennial generation getting married and starting their families later in life than generations prior. With this comes an increased demand for affordable single family homes as well as quality education, two metrics we follow closely within our target markets.
In order for your property to appreciate over time, you may need to invest in updates and renovations in addition to the ongoing maintenance and repairs. These capital expenditures can be costly in the short-term, but in the long run they substantially increase the potential for appreciation. So when you are evaluating a potential investment, it is extremely important to consider the capital expenditures that may be needed after your initial investment.
Is This Property a Good Investment?
After you have considered all of the variables and calculated your potential ROI, you’ll have to come to a conclusion on whether it’s an investment worth making or not. If you’re unsure about ROI you have projected, you may want to consider working with a partner that can walk you through the process we’ve highlighted above and more. Our friends at StoneCentury Financial can provide a complete breakdown of an investment property with their ROI calculator so that you know exactly what you’re getting into before investing.
Excelsior Capital is a real estate private equity sponsor based in Nashville, TN that specializes in yield generation by primarily focusing on stable income and capital preservation. Our strategy centers around our belief that real estate assets are undervalued in secondary markets that possess strong underlying economic fundamentals. Within these MSA’s, we target stable assets that are located in healthy submarkets and have a strong history of occupancy. To capitalize on this strategy, we focus on assets in the $10M-$25M range, which are often overlooked by institutional investors. If you’re interested in learning more about our investment approach, please reach out.
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