In this article, I will focus on the basic concept of return on investment (ROI), and how can investors entering the market use it to determine whether or not a real estate investment is sound or not.
By definition, ROI measures the efficiency of an investment. It answers the question “Just how profitable will this investment be?” ROI is always expressed as a percentage or a ratio, so to calculate ROI, you divide the dollar amount of the return by the total dollar amount out of pocket for the investment.
Here’s an example. I buy a home for $100,000 with cash, spend $10,000 on remodeling, and then rent it out for 12 months. My total out of pocket is thus $110,000. The rent is $1,200 per month, or $14,400 for the one-year period. What is the ROI for that year?
To calculate, we divide $14,400 (the return), by $110,000 (the investment), so our total ROI is 13.09%, which is considered substantial depending on the economic outlook at the time of acquisition.
Keep in mind that this is a gross (cash on cash), because I haven’t calculated in other likely costs that may surface during the year, such as taxes and insurance. The net ROI is more likely to be around 10% after those expenses which is still a good thing for many investors.
With a flipped home, if you spend $150,000 total, and make a $30,000 net profit when you resell, your ROI will be $30,000 ÷ $150,000, or 20%.
If you intend to flip a home, you need to calculate your potential ROI before you make an offer on the property. Accurate cost of repair is crucial to the bottom line. In addition, you will need to factor in expenses such as taxes, insurance, utilities, and vacancy rate. You will need to have a good experience/ knowledge of the price for which you can sell the home and this is where my expertise will help you.
- To find out the estimate of taxes- visit your county property appraiser’s website.
- Insurance costs: call few insurance companies to compare costs. Remember; rate may be higher than rental as the property is now vacant.
- Utility costs, call the local utility company and ask for the average costs for past 12-24. The number you will use should be less as your flip property is vacant.
This is where a lot of mistakes are made. When you flip a home, how and where you get your money from will determine your return. There are couple of options:
Hard money loans/ Private lender. Recommended to those with low credit score or unable to verify their income- these types of loans are a lien on the property you’re buying. It’s the most expensive form of financing. It usually has three upfront points (3% of the loan amount) paid at closing; the interest rate is generally 12–18%. The lender may finance 65%–70% of the after-repaired value (ARV) of the home, as determined by an appraisal they will do before you make an offer.
With such a high interest rate, the faster you rehab, list, and sell the home, the greater your ROI will be.
Conventional loans. These types of loans are typically for those with higher credit scores and able to prove income through variety of means. Investors using these types of loans usually have at least 20% to put down in addition to reserves. The cost of these loans is a lot less than hard money loan and they range 4–5%, with only 1–2 points on the loan. The downside of using conventional is that you can only buy so many properties before your debt to income ratio is jacked up.
Home equity line of credit (HELOC). The most cost-effective financing option is HELOC which is a mortgage on either your primary residence or another investment property. Banks will usually loan about 70% of the appraised value.
The advantages of the HELOC are the low interest rate (usually prime rate + 1% or 2%), and the fact that there are usually no closing costs or points. Several banks don’t charge for their appraisal. With the current prime rate at 2.5- 3.5 %, this is a very low-cost medium to finance your flips.
However, there is a downfall with these types of loans. Since HELOC has a variable interest rate, raising the prime rate by Federal Reserve will automatically raise your interest rate. The second is that the HELOC becomes a lien on the property to which it’s secured, so if you stop payments on the HELOC, the bank can foreclose on you.
Cash. Paying all cash is the absolute best scenario that will yield the highest ROI.
Investing can be a lot of fun and a great adventure with plenty of rewards and satisfaction. If done right, you will enjoy an ever- lasting financial independence.
Are you looking to assess whether investing in Real Estate will match your personality profile? Call my office today for a private conversation.
Written by Mona L Cherkaoui- licensed Real Estate Broker-Investor- and investment analysis Instructor.
Contact: Info@worldprogroup.com Or Call 407-992-4470