BiggerPockets

Understanding Leverage And Return On Investment (Roi)

The sale of investment property is a highly competitive field often with too little product, too many brokers, a good supply of buyers, and few real sellers. This is because the stakes are high and real estate investment, over the long haul, is a high-performing asset.

A great deal of the return on investment comes from leveraged appreciation of the asset value, which is normally based upon the income. Let me explain what I mean in simple terms, so you can plug in your local market numbers to create some real world examples: By leverage, we mean that the asset is being purchased with only a portion of the purchase price coming from the buyer and the balance coming from a lender. The loan will be repaid by the occupants' rental payments to the new buyer; therefore any increase in value of the entire asset represents a real return on the original amount invested. In short, the original loan will eventually be paid off by tenants and the investor will profit in the long run.

In very simple numbers it works like this: Suppose you contract to buy a one million dollar building, with a 25 percent down payment and another 5 percent in loan points, closing, and other costs. We can readily see that the investor has $300,000 of his or her own capital at work. If the property appreciates or increases in value at 3 percent per year, the next year the building would be worth one million thirty thousand dollars, or $30,000 more than the investor paid for it. Since the investor only has $300,000 at work, the return on investment is the $30,000 gained divided by the $300,000 invested. In short, the investor has made a 10 percent return on just 3 percent appreciation.

Return on Investment (ROI) = (Appreciated Value - Original Value) ÷ Amount Invested

If we add the appreciated return on investment shown above to the cash-on-cash return, which is the spendable income the asset produces after all operating expenses and mortgage payments are subtracted, the total return on investment is even greater.

If, in our simple example, the net spendable income were another $20,000, the return would increase by 6.67 percent. Remember, we arrived at this by dividing the $20,000 gained by the $300,000 initially invested. Loans payments may be a combination of principle pay-down and the interest. Unless the loan is an interest-only loan (in which there is no principle pay down), the true yield is actually even higher. Because some of the mortgage payment is interest, some of it goes to reduce the debt, which, in turn, increases the investor's equity position in the property. Since the mortgage is paid from rent collected, it is a real return on investment that shows up when the investor sells or refinances. However, in interest-only loans, which are common in commercial real estate, there is no principle pay-down.

Comments

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  Will Barnard — over 3 years ago

  ROI, cash on cash return, and total return can include a variety of factors depending on the investment. Principle pay down, for example is part of your total return. Tax deductions from depreciation can be included in ROI, cash on cash, and total return, as less tax paid, is more cash in your pocket. Many of these calculations can be manipulated so understanding them and knowing how to analize the numbers is of vital importance. Will B