What Is Return on Investment?

ROI?itm_source=ibl&itm_medium=autog&itm_campaign=glossary">return on investment (ROI) measures how much money or net profit is made on an investment, displayed as a percentage of the cost of that investment. It shows how effectively and efficiently investment dollars are being used to generate a net profit. Knowing the ROI allows investors to assess whether putting money into a particular investment, such as real estate, is a wise choice or not.

Return on investment can be used for any investment—stocks, bonds, or a piece of real estate. Calculating a meaningful ROI for a residential property can be challenging because calculations can be easily manipulated, and certain variables can be included or excluded.
How to Calculate Return on Investment

The return on investment formula measures the rate of return by subtracting the current value of the investment from the initial value of the investment and dividing it by the initial value. The ROI formula is: 

  • (Current investment value - initial investment value) / Initial investment value 

Or, it can also be calculated by dividing the investment return—your capital gains—by the original investment cost:

  • Investment return / Investment cost 

Since ROI is a profitability ratio, it gives us the profit on an investment represented in percentage terms. Let's say you bought stock in Apple (AAPL) for $5,000 and sold it two years later for $8,500. The profit is $3,500, and the ROI is 70 percent. 

Types of ROI

ROI is particularly useful when assessing a set of investment opportunities. Everything else equal, investors will opt for the investment that has the highest ROI. 
However, there are other return measures that are used to assess an investment's profitability:

  • The return on equity is a profitability measure that’s used on a company-wide level and not for specific investments. It’s calculated as net income divided by the average shareholder’s equity. This measures how well the company is using its assets. 
  • The internal rate of return determines the profitability of an investment or project—however, calculating it is a bit more involved than ROI. To find the IRR, one must use trial-and-error or a software program to find the interest rate that makes the net present value of all future cash flows equal to zero.

Calculating ROI on Rental Properties

The ROI equation might seem simple enough, but keep in mind that there are a number of real estate variables that can affect ROI. These include repair and maintenance expenses, as well as leverage">leverage—money borrowed to make the initial investment. Financing terms can greatly impact the overall cost of investment.

ROI for Cash Transactions

Calculating a property's ROI is fairly straightforward if you buy a property with cash. Here's an example of a rental property purchased with cash:

  • You paid $250,000 in cash for the rental property.
  • The closing costs were $10,000 and remodeling costs totaled $25,000, bringing your total investment to $285,000. 
  • You collect $1,500 in rent every month.

After a year:

  • You’ve earned $18,000 in rental income.
  • Expenses, including property taxes and insurance, totaled $2,500.
  • Your annual return was $15,500.

The property’s ROI is calculated by dividing the annual return ($15,500) by the amount of the total investment ($285,000). The ROI is 5.4 percent.

ROI for Financed Transactions

Calculating the ROI on financed transactions is more involved. For example, assume you bought the same $250,000 rental property as above, but instead of paying cash, you took out a mortgage:

  • The down payment needed for the mortgage is 20 percent of the purchase price, or $50,000.
  • Closing costs were $12,500 and remodeling cost $25,000.
  • Your total out-of-pocket expenses were $87,500.

There are also ongoing costs with a mortgage:

  • The mortgage was a 30-year fixed rate at 3 percent. On the borrowed $200,000, the monthly principal and interest payment is roughly $843.
  • We’ll add the same $208.33 a month to cover taxes and insurance, making your total monthly payment $1,051.33
  • Rental income of $1,500 per month totals $18,000 for the year.
  • The monthly cash flow for the property is $448.67 ($1,500 rent - $843 mortgage payment - $208.33 for taxes/insurance).

After a year:

  • Your annual return was $5,384.04 ($448.67 x 12 months).
  • ROI is calculated by dividing your annual return by your original out-of-pocket expenses, or $5,384.04 divided by $87,500.
  • The financed property’s ROI is 6.2%. 

Learn more: brrrr-increases-roi">How BRRRR Increases Your ROI

Depreciation and ROI

Deprecation represents the wear-and-tear an asset experiences over time. Per the Internal Revenue Service (IRS), residential real estate wears over 27.5 years. However, unlike other expenses, depreciation is a non-cash expense. This means you don’t spend any money, but the IRS still considers it an expense. This expense can offset taxable income and save money on your tax bill, which can ultimately boost your ROI. 

For example, consider the ROI of a rental property without depreciation. You have $30,000 in taxable income for your rental, for which you owe 25 percent in federal taxes, or $7,500. 

However, accounting for depreciation means you owe less in taxes. If you have the same $30,000 in rental income, you can deduct your deprecation from this—say, $17,500. Thus, your new taxable rental income is $12,500. At a 25 percent tax rate, you now only owe $3,125. 

Taxes aren’t generally included in ROI calculations, but for real estate investors, the depreciation expense can be a useful tool that makes rental property investing more advantageous than different investments.  

Negative Return on Investment

Return on investment is simply the amount of profit you make from the investment properties over a period of time. This percentage could be positive, indicating that your investment made money, or it could lose money and be negative.  

For example, assume you invested in a $200,000 rental property and after a series of unfortunate events had to sell it for $150,000. Your capital gain (or in this case capital loss) is $50,000. The ROI for the property would be negative 25 percent. 

Negative ROI can happen for a variety of reasons, including having a high turnover rate or long vacancy periods. 

Maximizing ROI for Real Estate Investors

To ensure a profitable rental property, you must actively work to boost the ROI by cutting costs and ensuring a steady occupancy rate. Cutting costs also means limiting your expenses, which is where maintenance expenses can play a part. Keeping up with rental maintenance can boost ROI over the long-term. 

Meanwhile, making sure you have your property rented consistently is the biggest driver for income. Having a high turnover rate means you're missing out on income and having to spend more on expenses to find and vet tenants.  

The other key to increasing rental ROI is increasing rent when possible. Increasing rental rates will help investors better manage rising expenses, which can include taxes, insurance and repairs.