One of the most important concepts for new real estate investors to understand is return on investment (ROI) in real estate and the calculations involved in determining it. A buyer in a real estate market is always at risk choosing or not choosing the accurate plan for investment.
People are always stuck in the calculations when it comes to borrowing money for real estate and spending at the right place. Real estate can be an excellent and profitable investment, but the projected ROI on these investments is frequently exaggerated.
ROI is a useful starting point for sizing up any investment. It’s always expressed as a percentage or a ratio, so to calculate it, we take the return on investment (ROI) at the numerator and we divide it by the total amount paid out of pocket.
Some people borrow money to invest in real estate. In that case, the real return on investment is calculated as the difference of the return and the cost of borrowing (rate of interest). For example the return on investment is 20% and cost of borrowing is 13% the difference will be their return on investment.
For example; Mr. A bought a house at Rs 60 lakh and spent Rs 10 lakh on construction of it. Later he gets a good deal and sells it at Rs 1 crore. The ROI for him will be 1crore divide by 60 lakh plus 10 lakh, which will come out to be 30% not 40%.
There are many ways to calculate the return on investment on real estate and it depends on type of investment.
Real estate can create returns in generally three ways i.e. appreciation, rental income and Mortgaging of property.
- Appreciation-The appreciation of property simply means increase in value of property over time. This increase is calculated after taking into consideration the indexed cost of acquisition. For example: If Mr. X bought one residential property for 5 lakh Rupees in 1985. And now in 2016 he’s selling it for 1 crore. Then his actual gain will be sale consideration less indexed cost of acquisition. Indexed cost of acquisition is (actual price) x (index in year of sale/ index in year of purchase). In this case the value of 1985 is 133 and 2016 is 1125. The capital gain will now be 10000000 less 4229323(500000/133*1125). For more information on capital gain and taxes.
- Rental Income-If one is calculating the ROI on its real estate investment given on rent then the rent received throughout will be the return and in case of sale of the same then rental income will also sum up to the return. Rental income simply has to be added to the gains as it is realized after the costs (like tax on property, maintenance, repair etc.) have been subtracted. However, without considering the cost of the investment, the return is meaningless.
- Mortgaging of property - Mortgaging of property is one more way of earning money. In this the owner mortgages the property in return of a fixed amount. The main idea behind this is to earn more than expected from the rental income. This concept is more common when someone is in need of urgent money and has excess land.
Calculating ROI on real estate can be simple or complex, depending on all the types of investments mentioned above. So maximize your ROI to be on your way to become a smart investor.