Real estate investing can be highly lucrative. But it all depends on the particular deal. Some real estate investments provide great returns, while others … not so much.
That’s why it’s so important to understand typical returns in real estate and how to calculate them.
In this post, we’ll go over different types of real estate investment returns, ways to measure them, factors that impact real estate investment returns, and more.
Let’s get started!
Before you can know what returns to expect from real estate investing, you need to understand the different ways in which real estate generates returns. These include the following:
Now that you better understand the ways in which real estate investing generates returns, let’s go over some common metrics you can use to calculate real estate investment returns.
The most basic return formula is return on investment (ROI). It goes like this:
ROI = Profit / Investment
In other words, you must divide the amount earned by the amount spent. So if you earn $10,000 on an investment that cost you $100,000, your ROI would be 10% ($10,000 / $100,000 = 0.1).
Cap rate is the most popular way to gauge a real estate investment’s return potential. It measures the return of a property over a one-year period, assuming the property is paid for in cash and not financed. The formula looks like this:
Cap rate = net operating income / current market value
So let’s say you want to buy a property that costs $500,000. After accounting for property expenses, the property brings in a total of $50,000 in operating income. In that case, the property’s cap rate would be 10% ($50,000 net operating income / $500,000 current market value = 0.1).
Cash-on-cash (CoC) return compares a property’s annual pretax cash flow to the total amount of cash invested. It’s particularly helpful for gauging the profitability of real estate investments that use a mortgage. Here’s how it’s calculated:
CoC Return = annual pretax cash flow / total cash invested
So let’s say you buy a property that costs $1 million by getting a mortgage that requires a down payment of $100,000 (10%). After one year, you also had to pay $25,000 in loan payments (of which $5,000 is a principal repayment) and $10,000 in maintenance costs, making your total cash invested $135,000 ($100,000 down payment + $25,000 loan payments + $10,000 maintenance costs = $135,000).
After one year, you also decide to sell the property for $1.1 million. Once you pay the remaining mortgage debt of $895,000 ($1 million mortgage – $100,000 down payment – $5,000 principal repayment = $895,000), your cash inflow would total $205,000 ($1.1 million sale – $895 remaining mortgage debt = $205,000), and your cash flow would equal $70,000 ($205,000 cash inflow – $135,000 cash outflow).
At that point, your cash-on-cash return would equal 51.9% ($70,000 / $135,000 = 0.519).
There are many factors that impact real estate investment returns. By understanding what they are, you can better assess property deals. Here are some of the biggest factors to consider:
The biggest factor that impacts real estate investment returns is location. Why? Location affects:
How much rent you can charge as rental housing demand and supply vary by area.
How much a property will appreciate as some areas are positioned for stronger economic growth and development than others.
Resale value since properties in areas with low crime rates, good schools, better amenities, and so on tend to command higher prices than those in undesirable areas.
Property type also impacts what real estate investment returns you can expect. Properties can be divided into two categories:
Commercial real estate, which includes office buildings, warehouses, hospitals, shopping centers, and other businesses.
Residential real estate, which includes single-family homes, multi-family apartment buildings, duplexes, condos, townhouses, accessory dwelling units (ADUs), and more.
We outline some of the pros and cons of investing in residential or commercial real estate here.
Real estate investing returns also depend on your investment strategy. Some of the most common investment strategies include:
The investment strategy (or combination of investment strategies) you choose will have a major impact on the returns you can expect.
Market conditions will also affect real estate investment returns. Some of the biggest components of the real estate market include:
Returns on real estate investments also depend on the type of financing you can leverage. On top of paying in cash, investors may be able to finance deals through:
As you can see, there’s a lot that goes into real estate investment returns. But if you want to know the average annualized returns of long-term real estate investments, it’s 10.3%. That’s about the same as what the stock market returns over the long run.
However, real estate offers a higher return than the stock market when adjusted for real estate investment risk. Compared to stocks, property values are less volatile and a less risky investment overall.
Interested in taking advantage of high returns with relatively low risk?
Then real estate investing might be for you. Just be aware of all the factors that affect your rate of return (discussed above).
And if you want to build a fixed-income portfolio of single-family rental (SFR) properties, consider investing in the Invest.net SFR Fund I.
It offers above-average cap rates as well as increased diversification with properties spread out across the midwest.
Contact us today to learn more. We look forward to chatting!