Annualized ROI Breakdown

by | Sep 16, 2016 | Crowdfunding |

Real estate investors use a variety of financial tools to make sound investment decisions. The most commonly used tool is annualized return on investment (ROI), sometimes known as capitalization rate. Return on investment (ROI) measures the amount of return on an investment relative to the cost and is calculated, simplistically, by figuring out how much you’ve earned compared to how much you invested. Slightly different from ROI, annualized ROI is the return of an investment over a given time period and it is calculated to demonstrate the amount an investor would earn if the annual return was compounded.

There are two main types of real estate investments that utilize annualized ROI: rental properties and non-rental properties. Despite both utilizing annualized ROIs, the methodologies for calculating these ROIs differ slightly.

Rental Properties

Investors seeking residential rental property prefer annualized ROI because it models the potential annual income the property will generate, making it a great tool for forecasting revenue.

There are four steps to effectively determine an annualized ROI for rental properties:

  • An investor must determine the potential annual income, which is calculated by comparing rents of similar properties in the area.
  • Next, the investor needs to determine the annual expenses that includes: projected vacancy costs, taxes, utilities, insurance, and repair costs.
  • Once the annual income and expenses are finalized, the investor subtracts the annual expenses from the annual income (rent – expenses) to determine the net income.
  • Finally, we divide the net income by the total investment that includes any remodeling and closing costs to calculate our annualized ROI.

Additionally, if an investor decides to purchase the property with a mortgage, the annual expenses will increase, which will reduce the net income. However, since the investor purchased the property with a smaller down payment, the total investment significantly decreases, which yields a higher ROI, despite the reduction in net income.

Non-rental Properties

Investors purchasing non-rental properties utilize ROI because it determines the amount of invested money that is returned to the investor after the property is sold. However, there are two different methods for determining ROI: The Cost Method and Out of Pocket Method.

The Cost Method

The Cost Method calculates ROI by dividing the equity by the total costs related to the purchases, repairs, and sale of the property. The equity is determined by subtracting the total costs from the sales price of the property (sales price – costs).

The Out of Pocket Method

The Out of Pocket Method is preferred by real estate investors because it yields a higher ROI. Investors purchase the property with a financed loan and a down payment, which decreases the amount of total costs. Thus, when we calculate the equity, we achieve a higher equity amount because our costs are lower, which results in a higher ROI.

Conclusion

In a robust economy, real estate investments have proved to be highly profitable, while a recession, provides many real estate bargains for investors with cash. Thus, understanding annualized ROI is essential for real estate investors because it provides investors a model of expected returns, which allows them to navigate any economic cycle.

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