Return on investment
Return on investment or ROI is the ratio between the profits and costs of an investment. It is a measure, frequently used by investors to evaluate the profitability of an investment or to compare the cost-effectiveness of different investments.
ROI’s application to real estate
In the real estate market, ROI is used to gauge the lucrativeness of a real estate investment as a percentage of its total cost. Principally, the return on investment is a metric of a property’s income-producing ability — higher ROI implies the property will surpass its price in profitability.
ROI values are also used for real estate comparisons. Return on investment on numerous properties available in the housing market are calculated, and the one with the highest ROI value is generally selected.
Due to its objectiveness, ROI has emerged as the best indicator for determining the value of a real estate investment.
How to calculate ROI
Return on investment follows an easy to understand equation:
ROI = (Revenue – Operational Costs) / Total Property Cost
Revenue – Total revenue generated by property over the period
Operational Costs – Expenses (maintenance, insurance, management, etc.) spent to generate revenue
Total Property Cost – Total money spent to buy a particular property, which includes all initial money spent to pay for property price, transfer fees, agency fees, etc.
Essentially, the return on investment is calculated for the life of the property (being bought to resold). Therefore, the profit or loss at the time of resale is accounted for from the revenue.
It is important to note that Yield and ROI are different concepts. Yield is the percentage calculated as Annual Rent divided by Property Price, and it does not consider any of the operational expense (maintenance, service charges) to generate that rent or additional costs (DLD fees, agency fees) paid during the purchase of the asset.
Criteria for ROI selection
Each investor has a different criterion that defines the strength of the ROI; different variables also come into play here. As a general rule, investors should consider the highest ROI in comparison to the market standards, but higher ROI might involve higher risks.