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!
Contents
Types of Real Estate Investment Returns
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:
- Capital appreciation is perhaps the most obvious source of real estate investment return. It refers to how much a property gains in value over time. So if you buy a property for $100,000 and you are able to sell it later for $200,000, your capital appreciation would be $100,000 ($200,000 – $100,000 = $100,000).
- Rental income is another common source of return in real estate investing. It refers to how much rent a property generates from tenants. According to World Population Review, the average American renter pays $1,326 per month for rent, and those who rent single-family homes pay an average of $2,018 per month.
- Tax benefits are another way in which real estate generates returns (in a roundabout way). Real estate investing offers a number of tax breaks like the ability to write off property management expenses, deduct property depreciation, and defer capital gains taxes through 1031 exchanges. As a result, you’ll earn more of your money back when you invest in real estate than you would if you invested in other less tax-advantaged assets.
- Leverage is one of the best features of real estate investing because it allows you to earn returns on borrowed money. For example, if you buy a $300,000 house with a mortgage that requires only a 20% down payment, you get to benefit from returns generated by the full value of the house ($300,000) and not just the $60,000 that you put in.
Metrics to Measure Real Estate Investment Returns
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.
Return on investment (ROI)
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).
Capitalization rate (cap rate)
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 return (CoC)
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).
Factors That Impact Real Estate Investment Returns
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:
Location
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
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.
Investment strategy
Real estate investing returns also depend on your investment strategy. Some of the most common investment strategies include:
- Buy-and-hold. This strategy relies on buying a property and holding it for a long period of time so you can profit from its appreciation.
- Fix-and-flip. This strategy (aka house flipping) involves buying distressed properties at a discount, renovating them, and then selling them again for a profit.
- Rent it out. This strategy relies on charging rent to long-term tenants or short-term guests (e.g. via short-term rental platforms like Airbnb or VRBO).
- Real estate investment trusts (REITs). This strategy involves investing in a trust that purchases and manages properties for you. It’s relatively hands-off, but it also comes with management fees.
- Private real estate funds. This strategy lets you invest in a private fund that buys and manages properties. Unlike most REITs, these funds aren’t publicly traded and offer more diversification as a result.
The investment strategy (or combination of investment strategies) you choose will have a major impact on the returns you can expect.
Market conditions
Market conditions will also affect real estate investment returns. Some of the biggest components of the real estate market include:
- Demographics. The demographics of a market’s population (people’s age, gender, race, income, etc.) have a big impact on housing demand and supply (and therefore also real estate investment returns). For example, many from the millennial generation (those born between 1981 and 1996) are entering the housing market, which could increase demand and potential returns on investment properties.
- Interest rates. Interest rates have a direct impact on mortgage rates, which have a direct impact on real estate investment returns. For example, if interest and 30-year fixed mortgage rates are above 6%, you’ll pay much more in interest over the lifetime of a home loan than you would if they were only at 3%.
- The economy. Real estate investment returns are also sensitive to the health of the overall economy as measured by indicators like global domestic product (GDP), unemployment rates, inflation, and more. If the economy is down, the real estate market probably is, too.
- Government policy. Government policy can have a direct impact on real estate investment returns through tax incentives, deductions, and subsidies. For example, in the aftermath of the 2008 housing crash, the U.S. government introduced a first-time homebuyer’s tax credit, which incentivized homeownership and increased investment returns as a result (the program expired in 2010).
Financing options
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:
- Conventional mortgages. These are traditional home loans that usually require a 20% to 30% down payment and good credit history.
- Hard money lenders. These are short-term home loans with high interest rates offered by licensed lenders. Hard money loans are easier to qualify for, but they also tend to be more expensive.
- Private money lenders. These are loans from private individuals, usually family members or friends, that are secured by a legal contract. Terms can vary widely.
- Seller financing. These are home loans offered by the seller directly. Essentially, the seller acts as the bank to whom the buyer makes a down payment and pays regular installments.
Average Returns on Real Estate Investments
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.
We’re also not factoring in how to use real estate investing to save taxes or how to make your money on the buy with the 1% rule.
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!
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