So far we’ve covered the paths investors can take to earn a profit in real estate. As a beginner investor, you can choose to follow any of them and still succeed – from owning your home to being a landlord, investing in REITs and more.
That’s quite exciting! In real estate, the possibilities are truly as broad as the time and expertise you are willing to put into it.
Now, there is just one crucial element left to learn to set you up for investing success: calculating your return on investment (ROI).
What is Return on Investment (ROI)?
At its core, Return on investment (ROI) compares your profit to the amount of money you spent to get it. It’s the most useful tool you will have for calculating how well your investment dollars are being used, and to separate potentially successful investments from potentially unsuccessful ones.
The basic ROI formula is:
Where profit is:
There are many ROI calculators online that use this formula and make calculations super easy, like:
- FinancialMentor.com Investment Calculator
- Calculator.net ROI Calculator
- GoodCalculators.net ROI Calculator
Of course, you don’t have to buy physical property to invest in real estate, and ROI doesn’t have to measure returns on physical assets either.
Real estate investment trusts (REITs), for example, are a type of real estate investment that can be traded like stocks on an exchange, without the need to own your own property. In general, REIT returns are more volatile than physical property, but their average annual rate of return is still 12.99% (U.S. data).
12.99% sounds like a great ROI! But is it really?
How do investors actually judge a good ROI from a bad ROI?
What Is a Good Return on Investment (ROI) for Real Estate Investors?
What one investor considers a “good” ROI may be unacceptable to another. It all comes down to your risk tolerance as an investor.
The more risk you are willing to take, the higher the returns you will expect. On the other hand, investors who are not comfortable with risk might happily settle for lower returns in exchange for more certainty and peace of mind.
As a general rule, to make real estate investing worthwhile, investors aim for returns that match or exceed the average increase in the stock market (specifically, the S&P 500).
Since its inception in 1926, the average annual return of the S&P 500 has been 11%.
So if your ROI on your real estate investment is less than 11%, you will generally be better off investing in an ultra-low-cost index fund that follows the growth of the S&P 500. Comparing this data to the average return of REITs (12.99%), we can see that REITs would generally be considered a good real estate investment ?.
Comparing potential ROI
Analyzing ROI is also important before making your first real estate investments. By doing so, you can confidently pick one property over another and avoid costly mistakes.
This calculation works the same as regular ROI, except that all the numbers are predictions and estimates. Instead of looking at your real gains and costs to calculate returns, you have to research what these are likely to be for your specific investment, and use those numbers to get started.
Then, to choose between your potential real estate investments you just have to identify which one delivers the higher overall rate of return.
The Bottom Line
Calculating ROI is a crucial skill for any real estate investor, and it will be even more important in the next few years.
After an economic crash or recession, prices fall, investors are uncertain, and volatility rules the market. This creates a lot of opportunities are created for bargains in real estate with higher than usual ROI.
The key is knowing how to calculate that ROI so you can spot those opportunities before they are scooped up by other investors. If you can find these properties, the next few years are shaping up to be a great time to enter the real estate market.
Join Us Next Week!
Calculating ROI might seem simple, but it isn’t as easy as it appears. Come back next week to learn about all the variables and complications involved in calculating ROI, as well as see some special formulas you can use for each kind of real estate investment.