While the global economy has experienced turmoil in recent years, the real estate industry has remained relatively unaffected.
With low property inventory in several markets, home prices are hitting record levels without a clear end. According to a market expert, the demand for home purchases will remain high, especially with the statements from the Federal Reserve highlighting a regime of "near-zero interest rates for the foreseeable future."
If you've ever considered real estate investing or are just an enthusiastic fan of popular house-flipping episodes, you've heard of real estate ROI. And as a homeowner, you may be looking to cash out and find alternative living places that meet your current lifestyle situation. For first-time and experienced investors, real estate ROI is a valuable tool to enhance the chance of a profitable investment.
This article explores everything you need to know before cashing out on your home.
What is ROI in real estate investing?
Return on investment (ROI) measures the amount of money or profit you've earned on an investment property as a percentage of its total cost.
In real estate, ROI is a metric used by investors to measure and evaluate whether they should buy a home and compare one investment property to another. It allows investors and homeowners to predict, using comparables, the profit margin they should achieve on their property through renting properties or flipping homes.
In general, ROI is a critical and vital tool in real estate investing because it provides homeowners a factual, concrete look at how profitable a property might be.
How to calculate your home's ROI in real estate
Return on real estate investment, or ROI, measures the profitability of an investment property and is typically presented as a percentage of the investment cost. As a homeowner, you make a net profit of $100,000 if you buy a home for $100,000 and sell it for $200,000. Since the gain is half your investment cost, your ROI is 50%.
The real estate ROI calculations can be made through two methods:
1. The cost method
The cost method is a popular approach to basic ROI calculation that involves comparing total investment cost with total revenues. The cost method can take into account income statements, cash flow statements, and financial ratios like net present value or return on investment.
For assets purchased entirely using cash, it's best to use the cost method of ROI because it's a straightforward way of determining your home's ROI. You don't have monthly mortgage payments to consider as there are none.
The cost method calculates ROI by dividing the investment gain by the property's costs.
For example, assume you bought a home for $200,000 in cash. After improvements and repairs, which cost you an extra $50,000, the home is valued at $300,000. In such case, your gain in the property is $50,000 ($3000,000 – [$200,000 + $50,000] = $50,000).
To calculate ROI using the cost method, divide the profit by all the costs related to the purchase, improvements, and repairs of the property.
Your ROI in the above scenario is $50,000 ÷ $250,000 = 0.2, or 20%.
It's imperative to mention that this method is based only on quantitative data, which means it doesn't include qualitative elements such as intangibles and strategic positioning.
In addition, the cost method may not always precisely reflect investments since it doesn't consider the time value of money or depreciated values over time.
However, despite its limitations, the cost approach helps compare various investment opportunities and determine which delivers the best ROI.
2. The out-of-pocket method
The out-of-pocket method is an ROI calculation method often preferred by many real estate investors as it results in a higher ROI.
To use the out-of-pocket method, take your total investment cash and subtract any money you've received from selling or renting the property. This calculation results in your net cash investment. Compare this amount to the specific property's current market value to get your ROI.
Using the figures from the example in the previous section, assume you purchased the same property for the same price ($200,000), but unlike last time, you financed the purchase with a loan and a down payment of $25,000.
Your out-of-pocket expense is $25,000 plus the $50,000 for improvements and repair, for a total of $75,000. With property valued at $300,000, your equity position or potential gain is $225,000.
In this case, your ROI is $225,000 ÷ $300,000 = 0.75, or 75%.
The ROI calculation derived from the out-of-pocket method is much higher than the ROI derived from the cost method. This difference, of course, is attributable to the loan leveraged to increase ROI.
The two calculation methods don't account for any rental income your home might produce or other ongoing costs like property taxes.
The out-of-pocket method is an excellent way to measure ROI in a short period, but it may not provide an accurate long-term perspective. Consult a trusted real estate professional like Mike Hogan for more detailed information.
What is a good ROI for real estate investors?
What one real estate investor considers a good return on investment may be unappealing to another. A good ROI in real estate investing varies by risk tolerance — the higher risk you are comfortable with, the higher ROI you might expect. Contrarily, risk-averse investors can readily settle for lower ROIs in exchange for more security and certainty.
However, to ensure real estate investing is worthwhile, many investors aim for returns that meet or exceed the average returns on a significant stock market index like the S&P 500.
Factors that can reduce your return on investment (ROI)
Several factors can negatively affect your real estate ROI. The most common reason for a low ROI is simply market conditions. But there are other potential reasons, including:
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Unfavorable market conditions. Generating a high ROI with adverse market conditions is difficult since the market can unexpectedly drop significantly in value.
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Poor investment choices. You might invest in risky properties that aren't performing well, causing you to lose money rather than make a gain.
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High costs and expenses. Some investment properties have unnecessarily high fees and expenses, leading to increased profits and reduced overall ROI.
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Taxes. You must pay property taxes on any profits earned, which reduces your ROI.
- Inflation. Inflation can reduce the demand and purchasing effect of your real estate investment returns, which means you can’t buy as much with the money you earn.
Several factors can reduce a property's ROI. However, being aware of these potential risks and making smart investment choices makes it possible to generate a healthy return even on an average real estate investment.
How to Maximize Your Property ROI
When preparing your home for a cash-out, you can take various essential steps to enhance your home’s chances of success in the market.
1. Hire an experienced real estate agent
A real estate professional like Mike Hogan understands the dynamics of your local market and the psychology of buying and selling the property. They will more than likely deliver for their fee. Working with an experienced agent can turn a possibly stressful process into something considerably pleasurable.
2. Be ready to spend
In real estate, you must be ready for the expression, "It takes money to make money." Making effective and strategic repairs and adjustments to your home will improve desirability, value, and demand, leading to more competition between buyers and, ultimately, a better offer price. Real estate pros can also help you handle best-kept strategies to make the most of your property sale.
3. Avoid investing in infrastructure
While you'll certainly need to present any structural issues with your property, now isn't the best time to rebuild a deck, install a new roof, or retrofit the foundation. These are unnecessary and significant investments the new owner will take on, and the costs will be factored into the price offered. Moreover, such investments typically fail to deliver a positive ROI, especially when projects are time-consuming and complex.
4. Emphasize aesthetic, cosmetic appeal, and space
It's often impossible to predict what a buyer will want to do with your property once they own it, so don't even try. You should focus on cosmetic appeal, cleanliness, and space. Start by emptying the house, then consider improvements such as installing an affordable ground cover and trimming trees and bushes. Interior and exterior painting can be appealing even if there are other costly repairs the buyer will need. And investing in kitchen remodeling with new countertops and appliances is an inexpensive way to modernize and refresh a kitchen. Most importantly, be prepared to spend on high-quality staging.
Why is evaluating ROI important for a real estate investment property?
Real estate investing is a critical, long-term commitment. Determining ROI can help you decide whether or not to sell your investment property. It typically represents the income-generating asset's potential. The higher the ROI, the better the potential return on that investment.
Calculating ROI in real estate is important because:
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It makes it easy to understand the profitability of an investment opportunity.
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It helps you make informed and intelligent choices about selling an investment property.
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You can use ROI to compare different property investments.
Final Thoughts
When it comes to real estate investing, making decisions based on your property's ROI is vital. When you understand the different methods of calculating ROI and the factors that affect it, you can make informed choices about your investments.
However, as you determine what ROI calculation best represents your situation, it's important to remember that not every home will produce an accurate positive return — and this doesn't mean your property wasn't a good investment. Based on various factors such as length of ownership, condition, neighborhood, and market factors, the appreciation of the property after expenses likely isn't enough to pay you for ownership there. Still, it may be able to offset the housing cost significantly.
Above, we discussed all the essential factors to consider when evaluating real estate ROI and how to maximize returns. The best bet so far is to hire an experienced agent from The Hogan Group and get practical help on your real estate investing issues. Contact us if you want to buy or sell property in the Central Virginia area with real-time property updates.
