Return on investment, or ROI, in real estate 2024

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When you’re considering a real estate purchase as an investment, it’s important to have an idea of how much you stand to earn in return for the money you’re spending. This is known as return on investment or ROI. Here’s how to assess ROI and the factors that may impact how much an investment pays off.

What is ROI on real estate?

ROI is the profit earned from a real estate purchase after deducting various costs associated with the investment, which typically include the purchase price and any additional expenses associated with repairs or remodeling. ROI is realized throughout ownership, when your property generates income, and upon sale, when you realize a capital gain or loss.

“ROI is meant to measure how much you earned on the money you spent on an investment,” says Greg McBride, chief financial analyst for Bankrate. “You must factor in all of your out-of-pocket costs for the down payment, closing costs, financing costs, property taxes, property insurance, maintenance, repairs and upgrades.”

One of the most common ways to make money investing in real estate is through appreciation, or when the property grows in value over time. For example, if you purchase a home for $300,000 and, over the course of five years, its fair market value increases to $400,000, that means it has appreciated by $100,000. Let’s say that in addition to the $300K you bought the home for, you also spent $40K on improvements and made $20K in rent, and you’re now selling it for $400K. Following the formula above, that’s $20K (operating income) plus $400K (sale price) minus $340K (cost), which comes to $80K; $80K divided by $340K is 0.235, so your ROI is 23.5 percent

There are many different types of residential properties to consider investing in, beyond just single-family homes. Condos, townhouses and multi-family homes can also be good investments, and you might even consider investing in tiny houses or ADUs (accessory dwelling units). It’s also possible to invest in land that has no existing structures on it.

“The breadth of real estate as an investment is as expansive as one might want to consider,” says Mark Hamrick, Bankrate’s chief economic analyst. “What is best for an individual varies based on their objectives.”

How is ROI calculated?

ROI = (operating income + sale price of investment – acquisition cost) / acquisition cost

• Resales and cash sales: In cash sales and resale transactions, calculating ROI is often fairly simple. Subtract your total investment cost from your final sale price (often referred to as “gain”), then divide that number by the investment cost number. The result of this calculation is the ROI.
• Rentals: Owning a rental property can generate steady long-term income. Determining ROI for rentals requires first calculating your projected annual rental income and your annual operating expenses, which could include such things as insurance, property taxes, HOA dues and maintenance costs. Your ROI for a rental property can then be calculated with this formula: ROI = (annual rental income – annual operating costs) / mortgage value (i.e., the amount that still needs to be paid on the mortgage loan).
• REITs: REIT stands for real estate investment trust. Rather than an individual calculation, this passive approach to investing in real estate involves buying shares in an REIT and earning dividends, similar to owning stock. (Some REITs are, in fact, publicly traded.)

Other ways to gauge investment profitability

Potential investment profitability can be assessed in several ways, and it’s not unusual for investors to combine multiple metrics to create a more complete picture. Other common metrics include:

• Capitalization rate: This measures the annual, debt-free rate of return from a rental property. The formula involves three variables — net operating income, property value or price and rate of return — any one of which can be calculated using the other two.
• Internal rate of return: IRR requires a more complicated calculation than ROI, and it measures the annual rate of return over a particular time period, rather than over the total time of ownership.
• Cash-on-cash return: This simple formula compares annual pretax cash flow from a property to the total amount of cash invested. Cash-on-cash calculations typically measure returns over a very specific time frame, such as one year.

Variables that can impact real estate ROI

The potential profit or ROI for a particular real estate investment can be affected by various external factors. One of the biggest is the overall market conditions at any given time. For example, when there’s limited inventory available, it typically drives up the sale price of properties that are on the market. This type of seller’s market can significantly increase ROI.

The cost initially paid to purchase a home also factors into the profit investors stand to earn when they’re ready to sell. The more you paid for a property, the less money you stand to pocket in the end — unless the value has appreciated significantly.

Prevailing mortgage rates can also impact profits when selling real estate. When interest rates are high or on an upward trend, real estate sale prices often decline in order to attract wary buyers (though that’s not the case in today’s market). A lower sale price means less profit on the sale.

Location is another factor that can increase or decrease the ROI of a real estate investment. A home set alongside a highway, for instance, is likely to command a lower sale price than one near a park or beach. “If there’s one popular phrase about real estate, it is ‘location, location, location,’” says Hamrick. “The locality, including neighborhood appeal, safety, proximity to schools, entertainment, health care and transportation, such as mass transit and airports, can affect return on investment.”

The cost of building materials required for construction or renovations is another thing that impacts ROI. When goods such as lumber and other materials are especially expensive, it drives up the amount spent on such projects, which in the end, cuts into profits earned on the property when sold.

FAQs

• What is a good ROI in real estate?

  Return on investment is variable and depends on a lot of factors — there’s no one-size-fits-all answer for what is considered a “good” ROI. According to the S&P 500 Index, the average annual return on investment for residential real estate in the United States is 10.6 percent, so anything above that can be considered better than average. Commercial real estate averages a slightly lower ROI of 9.5 percent, while REITs average a slightly higher 11.3 percent. ROI can also vary by property type, so it might work out differently for a multi-family home than for a single-family home or an apartment building.

• How do you calculate ROI in real estate?

  There is a simple equation that can be used to calculate ROI in real estate: ROI = (operating income + sale price – acquisition cost) / acquisition cost.

• What steps should someone take to become a real estate investor?

  If real estate investing is of interest to you, there are several steps you might take to get started. First, think about what kind of investor you want to be. Are you looking to be active and hands-on, such as fixing up properties and flipping them? Or do you prefer a more passive approach, like investing in an REIT? Additional steps to get started include researching the market you plan to invest in and learning about local real estate laws.