As an investor, you probably know that having an idea of your return on investment (ROI) is an important part of making an investment decision. Still, fewer investors can articulate what a return on investment calculation is and what it tells you.
With that in mind, we've created a guide on ROI below. Keep reading to learn how to do this calculation and why it should be part of your investment analysis.
What is a return on investment (ROI)?
At its core, return on investment (ROI) is a financial metric that can be used to evaluate the profitability of an investment. By the same token, an ROI measurement can also be used to make a comparison between the profitability of a number of different Investments. ROI can be used to calculate the profitability of a number of different assets, including stocks and real estate.
Fortunately, calculating the overall ROI of an asset is fairly simple. All you need to do is divide the net profit you've received from the investment by the cost of the investment. The result is expressed as a percentage and can either indicate a positive ROI or a negative ROI.
How to calculate ROI
Now that you have a better idea of what return on investment is, the next step is to learn how to calculate it. With that in mind, we've laid out the ROI formula for you below.
ROI = (Total Revenue from investment - Cost of Investment) / Cost of Investment
Using the ROI formula: A practical example
For the purposes of this example, let's pretend you're doing an ROI analysis on an investment property. Let's imagine the following scenario:
- You buy a rental property in cash for $200,000.
- Your closing costs and some small renovations to the property cost $20,000, which brings your total investment to $220,000.
- The property rents for $2,000 per month.
A year later, your income and expenses for the property are as follows:
- You've made $24,000 in total revenue over the last 12 months.
- However, your expense report for the property indicates that you spent $5,000 on maintenance and upkeep.
- Therefore, your investment return is $19,000 ($24,000-$5,000)
- Divide the investment return by the total investment.
- ROI = $19,000 / $220,000 = 0.0863
- ROI = 0.0863 x 100
- ROI = 86%
Why ROI is important in real estate
Truthfully, when you're thinking of investing in real estate, doing an ROI calculation can make you a more informed investor. For example, you can use the ROI metric to help you make the best financial decision if you are debating between buying one of two properties.
Put simply, once you know how to calculate an ROI measurement, you can perform this calculation on both properties. Then, when you're able to compare the numbers, the property with the higher ROI is likely to be the better investment for your money.
What are the pros and cons of using an ROI calculation?
Like any investment decision, a return on investment calculation has its advantages and disadvantages. We've laid them out for your consideration below.
The biggest advantage of an ROI calculation is that it is fairly simple to perform. While other investment metrics definitely require an understanding of complex mathematical equations, this one is a bit easier to wrap your head around. It can provide you with a rough estimate of your profit margin fairly quickly.
Additionally, as we mentioned above, this metric can help you make more informed investment decisions. When considering buying a property, it is absolutely crucial to have an idea of your expected investment return, and an ROI calculation can help give that to you.
The main disadvantage of an ROI calculation is that it is just an estimate. Specifically, it's an estimate that is only as good as your analysis of your total revenue and total cost. In real estate, there are many factors that go into determining your ROI figure, including financing costs and maintenance costs. This means it can be harder to estimate your expenses, which can make it difficult to estimate your actual ROI.
Similarly, return on investment has its limitations. For instance, it doesn't take into account the time frame of your investment. That's why it's important to perform a thorough investment analysis before you make any financial decisions and to use ROI in conjunction with other metrics, such as a rate of return calculation or net present value (NPV) calculation.
The bottom line
At the end of the day, an ROI calculation is a handy tool for every real estate investor to keep in their back pocket when evaluating properties. However, it's important to remember that what makes a "good ROI" is often subjective and that a return on investment calculation is only one part of investment analysis.
If you want to learn more about how to prepare a thorough investment analysis, check out our guide on the subject.