Owning a real estate property could provide investors with stable rental income as well as capital appreciation when such property is sold off. However, it’s important to calculate the ROI (return on investment) to determine the profitability from such property.
For investors wishing to diversify their portfolio by adding real estate investments, it’s crucial to measure the ROI for determining a property’s profitability. ROI measures profit or how much money is made on a given investment as a percentage of the cost of such investment. ROI signifies how efficiently and effectively the investment is being used for generating profits.
When investing in real estate, your ROI is equal to your real estate property’s cash flow, i.e. its income minus expenses, and also the equity which builds up. Your return on the real estate would depend on several variables. You have to consider the overall income of your investment. The return which your real estate property would generate is just the initial piece of the entire puzzle. This includes rental income as well as capital appreciation.
Before working out the ROI, the next step is to calculate how much fund you are pouring into your real estate investment. You can’t solely consider your deposits, in case you are using a mortgage for acquiring your property. Your first major expense would be the financing expense, and you would need to understand how much you need to borrow, the interest rate you could obtain and the term of the loan. Over and above the financing expenses, you might have to pay several other costs, which could include:
To arrive at the ROI, generally, investors would add up all the expenses they make out of their pocket from acquiring the investment property to making it generate income on its own.
Below is an outline of how to calculate ROI
Let’s take an example of a property which costs Rs. 10 lakh, and cost of transfer (conveyancing fees, stamp duty, deeds office fee) are Rs. 1 lakh making the total investment Rs. 11 lakh and the rent collection every month is Rs. 10,000. The profitability from such property is worked out as follows:
A down payment of Rs. 2,00,000 is made, and the remaining Rs. 9,00,000 is bonded on a 20-year home loan with the interest rate of 10%.
The monthly principal and interest payment would be Rs. 8,685. It will further include Rs. 1,000 per month for covering maintenance, levies and insurance, property taxes making it Rs. 9,685 in expenses every month. With a rental income of Rs. 10,000, the owner will make a profit of Rs. 315 each month (rent minus bond repayment)
After a year:
The investor earns Rs. 1,20,000 as total rental income for the year (Rs. 10,000/month).
The annual income is Rs. 3,780 (Rs. 315 x 12 months)
The capital appreciation of such property after the selling costs has increased by 3%, i.e. Rs. 33,000 (Rs. 11,33,000 – Rs. 11,00,000)
Calculating return on investment
Divide the annual return by out-of-pocket expenses (down payment of Rs. 2,00,000) for determining the ROI.
ROI: (Rs. 3,780 + Rs. 33,000) ÷ Rs. 2,00,000 = 0.18
The ROI is 18%
Depending on the existing financial situation, the income which is generated from your real estate property could be chargeable to tax. You are allowed to deduct the expenses from your rental income and whatever is left would be considered as part of your taxable income. Additionally, in case you sell your real estate investment at a profit, you would need to pay the capital gains tax depending on the duration of such an asset.
In the example above, we assumed that the real estate property received rent for all 12 months. In some cases, vacancies could occur and such a lack of rental income for such months should be factored for ROI calculations. Further, the return on investment for a real estate property would vary depending on whether such real estate property is paid for in cash or financed through a mortgage. As a general thumb rule, lesser the cash paid up front, larger the mortgage and greater the ROI. On the other hand, more the cash paid up front and lesser the mortgage and lower the ROI. In a nutshell, financing enables you in boosting your return on investment in the short-term as the initial cost is lower. Also, it’s important to use a consistent approach for measuring the ROI for all your properties.
The bottom line
Figuring out the return on investment from your real estate property could be multi-factorial and complex, as per the variables involved and differences of opinion on how to reach that number. However, calculating the return on investment is an essential step to determine whether the investment is likely to show a profit now and also in the future.
In a strong economy, investing in the real estate property, both commercial as well as residential has proven to be quite profitable. Even during the recession phase, when prices are falling, and there’s a cash crunch, bargains in the real estate space are still available for an investor with money to invest. When an economy recovers, as it would invariably, most of the investors would reap a handsome profit. Hopefully, this blog would help you in arriving at the ROI of your investment potential.
Disclaimer: This article is intended for general information purposes only and should not be construed as investment or tax or legal advice. You should separately obtain independent advice when making decisions in these areas.
Writer Profile: Mr. Sandeep Kanoi is a Practicing Chartered Accountant from Mumbai. He has been associated with Taxguru.in right from the start of the website. Currently, he is also the CEO of Taxguru Consultancy & Online Publication LLP. He has more than 17 years of experience in the field of Taxation, Accounting, Finance, Audit and Corporate Law.