Return on Investment in Real Estate
10 min read
Every investor expects a “return” on their investment. Return on investment (ROI) is the money an investor gets back over time in exchange for the resources (time, manpower, materials, and money) they allocate to a particular investment.
ROI is usually expressed as a percentage. If an investor puts in $100,000 worth of resources and gets back $120,000, that extra $20,000 above the initial investment represents a 20% ROI.
What is ROI in Real Estate?
The ROI of real estate is the money an investor gets back from an investment in property, over and above what (s)he put into it.
The initial investment consists of all funds used to acquire and rehab the property including:
- Purchase Price. If the investor plans to leverage the property with a mortgage loan, this component would actually encompass not the full purchase price, but the down payment on the loan.
- Closing Costs. Any fees and expenses required to close the transaction.
- Initial Rehab, Renovation, or Repositioning Costs. This might include a cash reserve to correct deferred maintenance, perform upgrades, or build new structures from the ground up.
So what does ROI mean in real estate? There are several components to consider:
Components of ROI on Rental Property
Cash Flow from Rent Revenue
If a property produces more rental income from its tenants than it incurs in expenses — including operating expenses and debt service — the excess cash flow forms the first component of the ROI of that property.
An advantage of cash flow from rent revenue is that it is liquid cash available right now. The more cash flow, the less risky the investment because you have cash on hand to weather obstacles.
Appreciation of Property Value
Real estate is known for its ability to appreciate in value — that is, become more valuable over time. This could happen due to:
- Improvements you make to the property, although not all improvements produce more value than the expenses they incur. Improvements that tend to add value include additions (extra square footage) and anything that increases the net operating income (higher rent, lower expenses, etc.)
- Market forces. In growing local economies, or along a city’s “path of progress,” real estate tends to appreciate in value due to increased demand for property in the area.
Note that appreciation of property is not guaranteed, especially over the short term. Real estate markets move in cycles, and it also depends on the usability of the property. If you catch a downward trend or if the property falls into disrepair, it could actually decline in value.
However, with proper maintenance and the passage of enough time, real estate does tend to gain value over time. If you buy in the right area and catch an upward trend, the property could appreciate very quickly indeed.
If a real estate investor leverages their investment with a mortgage loan, they increase their exposure to appreciation. For example, if they buy a $100,000 property and it appreciates $20,000, that’s a 20% ROI. But if they buy the same property with a mortgage loan and 20% down (i.e. $20,000 down), that $20,000 appreciation actually represents a 100% ROI.
However, leveraging property with a mortgage loan comes at two costs. It:
- Reduces the cash flow due to the extra expense of the mortgage payment, and …
- Adds risk to the investment, since default on the loan can result in foreclosure and total loss.
While appreciation can produce big ROI (especially if you leverage the asset with a mortgage loan), it is not liquid. You will only realize that appreciation as liquid cash if you:
- Sell the property. This is a taxable event that ends the investment cycle. Or …
- Refinance the property into a larger mortgage loan and pocket the difference, at the expense of a reduction in cash flow due to the higher mortgage payment. This is a non-taxable event that prolongs the investment cycle.
While many real estate investors target positive rental cash flow, they also target a big windfall profit at sale due to appreciation. This windfall often represents the lion’s share of the ROI on the real estate investment.
Paydown of Mortgage Principal
If the investor leverages a real estate investment with a mortgage, part of each payment usually goes to interest on the debt (basically the price you pay for the right to borrow). But part of each payment also goes to reducing the principal balance of the loan.
Early on, the payments are mostly interest and very little principal paydown. Over time, however, the interest gets smaller and the principal repayment bigger.
(NOTE: This only applies to amortized loans. “Interest-only” loans include no principal paydown.)
As the balance of the loan gets smaller, your equity in the property increases — that is, the difference between the value of the property and the debt attached to it. If you spend several years holding the property and making regular mortgage payments, that debt reduction becomes significant.
These principal reduction payments are considered a debt-service expense, not a part of the initial investment … which means principal recapture represents a part of your ROI on the property investment.
Tax Savings
The US government wants to incentivize private investors to develop property at their expense and their risk. As a result, the US Tax Code includes many tax advantages for real estate investors, including several only available to investors and not to homeowners.
Examples of these tax advantages include:
- The ability to deduct expenses. Homeowners can deduct their mortgage interest, but not their insurance, repair expenses, rehab expenses, utilities, or property taxes. Real estate investors can often deduct all of these expenses from their taxes.
- The ability to deduct depreciation. Another advantage only available to real estate investors and not homeowners is the ability to write off a portion of the value of the property as an “expense” for “wear-and-tear.”
This is called depreciation, and you get to take the deduction even if you didn’t spend any money out-of-pocket to correct the wear-and-tear. And if you did perform repairs to correct the wear-and-tear, that expense is also deductible.
If you sell the property at a profit, you have to “recapture” that depreciation with extra taxes on the income, but that recapture is often capped so at least some of the depreciation deduction becomes permanent.
- The pass-through deduction. Real estate investors who hold their investment in a “pass-through” entity, like an S-corp or LLC, get to take an extra tax deduction against their revenue.
- Long-term capital gains taxation. If you hold a real estate investment for more than a year, the profit at sale gets taxed as a long-term capital gain, a rate lower than the ordinary income rate.
Since everyone’s taxes are different and laws keep changing, the tax advantages of any given real estate investment are hard to quantify, so they usually don’t get factored into ROI calculations. However, many real estate investors find that the tax savings make even a mediocre investment worthwhile.
Protection Against Inflation
In periods of currency inflation (which is basically all of recent history in the US), real estate tends to get more valuable.
At the same time, existing mortgage balances become less valuable, since the currency is losing purchasing power but the loan balance doesn’t change in reaction to this — it stays the same.
As a result, real estate investors tend to get wealthier faster in times of high inflation. Again, this is hard to quantify in ROI projections since inflation can be hard to predict. But savvy real estate investors are aware of this effect and consider the impact of inflation in the final analysis of a completed investment.
How is ROI Measured in Real Estate?
There are several “measuring sticks” you can choose to calculate the ROI of a given real estate investment:
Cash-On-Cash Return
Cash-on-cash return (CoC) is simply the annual cash flow as a percentage of the initial investment. For example, if the initial investment was $20,000 and the investment produced $2,000 in positive cash flow for the year, the CoC for that year is 10%. If next year it produces $1,800 in cash flow, the CoC for that year is 9%.
CoC is useful for predicting the solvency of an investment and measuring it against the return available from other investment vehicles, like stock or bond indices. For investors who hold real estate long-term and don’t prefer to bank on appreciation, it may be the only number they care about.
However, CoC fails to take into account appreciation, paydown of loan principal, tax savings, or inflation.
Total ROI
The total ROI on a real estate investment is all the money made from an investment, expressed as a percentage of the initial cash investment.
Let’s say an investor made an initial cash investment of $100,000 and held the asset for five years. Over those five years it generated $20,000 in cash flow. The real estate investor then sold the asset and realized $180,000 in proceeds after the loan and all closing costs were settled.
Cash Flow: $20,000
Proceeds From Sale: $160,000
Total Income: $180,000
Initial Investment: $100,000
Net Profit: $80,000
This investor realized an 80% total ROI, having gotten back $80,000 over and above the initial investment when you factor in both the cash flow and the sale proceeds.
Total ROI takes into account cash flow, appreciation, and loan principal paydown. If the investor wants to go the extra mile, (s)he may try to factor in taxes and appreciation as well.
Annualized ROI
Whereas total ROI produces exciting numbers, it’s important to factor in the time it took to realize those gains. It’s great to double your money … but if it took you fifty years to produce that doubling, that’s only 2% per year — not even fast enough to beat inflation.
Many investors consider the annualized ROI of their investments — the total ROI divided by the total time cycle of the investment in years.
In the above example, the hypothetical investor realized an 80% ROI over five years. 80% divided by five years gives us an annualized ROI of 16%. This number enables the investor to compare the investment to the annual performance of, say, the S&P.
It is important to remember that the investment didn’t produce that 16% at a steady clip like clockwork. Much of that gain was realized at sale, at the very end of the investment cycle. The annual realization of cash flow would be measured by the cash-on-cash return — a much lower number.
Internal Rate of Return (IRR)
While annualized return takes into account the time cycle of the investment, it does not take into account the time value of money.
The assumption of the time value of money is that money now is more valuable than money later, so a big windfall at sale is actually worth less than a big windfall would be right now due to the opportunity cost of committing that money over time. As a result, comparing annualized ROI to a more liquid investment vehicle, like the S&P 500, is not entirely accurate.
Internal rate of return (IRR) is a metric that takes into account opportunity cost and the time value of money. It is a complex calculation, usually best left to the =IRR function on a spreadsheet. When you apply it to a real estate investment with a big windfall at sale, it produces an annualized percentage slightly lower than the simple annualized ROI.
While it is complex, IRR is a more accurate way to compare a real estate investment to a more liquid investment vehicle.
What Is A Good ROI in Real Estate?
Determining what is a good return on investment in real estate depends on three things:
- The investor …
- The investment, and …
- The market
Different investors have different target ROI. One investor may be happy with a 7% cash-on-cash return; another might not get out of bed for less than 10%. Another might not care about the CoC as long as they realize an IRR of 12%; another might see failure below 15%.
The investment also makes a difference. The riskier the investment, the higher the target ROI to justify the risk. A turnkey rental is relatively low-risk — it’s already in good condition and ready to start generating rent revenue immediately. An investor can reduce the risk even further by borrowing little or no money to leverage it. But, as the risk goes down, so does the potential ROI.
By contrast, a teardown or a ground-up development has a lot of risk. A lot can go wrong with construction — delays, cost overruns, etc. — and the property won’t start producing income until construction is complete. Add to that lots of leverage in the form of a big loan, and you have a lot of risk … but a big potential ROI.
Finally, the market plays a role. In an expanding economy, investors may be used to fat ROI with little effort. But as the market contracts, it may become harder to produce those gains. Investors may have to settle for smaller ROI and focus on the benefits of tax advantages and protection from inflation.
Considering all these caveats, here are some good “rule-of-thumb” annualized ROI targets for various classes of investment:
What is a Good Return On Investment on Real Estate Development? (Teardown or Ground-Up, highest risk)
35%+
What is a Good ROI on Property Flipping? (Rehab, Fix-And-Flip)
25%-35%
What is a Good Return on Rental Property? (Speculative, Full Rehab)
18-25%
What is a Good ROI on Rental Property? (Value-Add)
12-18%
What is a Good ROI on Rental Property? (Core, Turnkey, lowest)
8-12%