Statistically speaking, the average annual return on real estate is better than the return on investment in stocks. There are many factors that need to be considered while calculating the net income from real estate. One thing, that should be kept in mind is, income and profit are two different things. Income, if explained in layman terms, is the total revenue generated with any business or financial activity. On the other hand, profit is explained as a figure obtained after deducting various expenses from the income.
Now, return on real estate is different for different categories. Concisely narrated, real estate is categorically divided into three sections. One, real estate used for commercial purposes (commercial real estate). Two, real estate for domestic purposes (residential real estate). Three, Real estate investment trusts (REITs). The rate of return is different for all these categories.
Talking about figures, if the return is averaged for the last 20 years, the average annual rate of return for properties used for commercial purposes is 9.5% while the figures for return on residential properties are even higher and that is 10.6%. The third category, Real estate investment trusts (REITs) has topped the table with a whopping return ratio of 11.8% annually. These stats are portraying a clear picture that returns on real estate investment have outperformed the return on stocks which, on average, is 8.6% annually for the last 20 years. The best thing about real estate return is it yielded higher returns as compared to stocks even during the famous market collapse in real estate prices in 2008.
As mentioned earlier, real estate is divided into three main categories with commercial and domestic are the most common and oldest types. Domestic or residential properties include single-family or multi-family houses, residential apartments, raw or agricultural land, mansions, hostels, etc. While, commercial properties including, shopping malls, commercial shops, offices, franchises, etc. The third option is investing in REITs, which also invest in the above mentioned traditional options but REITs are managed by professionals with expertise in the related field. That’s the reason REITs are more successful as far as return on investment is concerned.
What is a good return for investment in real estate?
This question is hard in terms of a general answer because there are so many factors involved in the process and the outcome. For example, the rate of return shows variations in different locations, different markets, the difference in the categories of properties, and some other geographical factors as well. For example, the return on agricultural land will be variable in different areas. Some lands are good and fertile for agricultural purposes and they yield more output and thus if they are rented or leased, they will give higher profits and vice versa.
Similarly, the rate of return will be different for the properties located in cities or you can say “big cities”. This rate is different for commercial properties and residential properties. While this return rate will be lower for properties situated in the countryside or away from “crowded areas”. For example, many counties in Florida saw a booming rate of 17% annually while the vacancy percentage was near 5%. Moreover, some counties had astonishing low rental rates although they are located in metropolitan locations which are deemed to have very high rental rates. For example, talk about famous New York, which includes two counties, San Francisco and Manhattan. Their rental rates were astonishingly low that is, 3.16% and 2.4% respectively. Mostly, investors in Florida prefer purchasing low price properties and then sell or rent out after renovation for “big bucks”.
How to calculate Return on investment (ROI)?
Being moving towards the calculation of ROI, you must know that there are mainly three modes or channels for earning from real estate business:
- Earning through rentals: One of the biggest and oldest way of earning in real estate.
- Through appreciation in the price of a property and selling it with a profit.
- Receiving dividends from investments in REITs.
Now, while calculating the return on investment. There are things that need to be understood. While calculating accurate return on income, there are things that are important:
- Expenses: They may include maintenance expenses, renovation expenses, reconstruction expenses, etc.
- Taxes: Just like every other income, income from real estate is also taxable.
These two things are deducted from your total real estate income to make accurate figures. Let’s discuss this with an example that will give you a better picture of how things are. Assume you bought a property worth $100,000 (cash basis) and you are going to rent it out. Now, for the sake of this example, let us assume that after deducting all the expenses, your net operating income (NOI) is $10,000 annually. You are planning to sell your property after fifteen years. Now, if the annual net operating income is held constant for the next fifteen years and you sell your property for $250,000 after fifteen years then, not only you have earned 10$ annual rental income but you also earned a profit of $150,000. So, the net profit you earned in these fifteen years is $300,000 ($150,000 through rental income + 150,000 through value appreciation). You have expended your money four times as compared to your original investment. Be noted that tax is not deducted from this figure.
Now, let us redo this example with a different approach. Assume that you purchased this same property for $100,000 but this using the mortgage option and you made a down payment of $20,000 and the annual net operating income is $10,000. Now if sell your property after fifteen years at the same above mentioned price. This time, your net profit will not be $300,000 because you will have to deduct the amount of interest you were paying against that mortgage.
In these examples, the amount of investment, rate of return and appreciation values were the same. Yet, one approach yielded higher profits than others. The reason behind that was the “mode of financing.
While calculating the return on investment, you cannot neglect one of the most important factors and that is the inflation rate. Now, that above-explained example, where net operating income was kept constant (which also seems to be impractical) and inflation factor was also ignored. The purchasing power of $100,000 today is different and after fifteen years, it will be a whole lot different. That means, if those $300,000 are discounted for present value (keeping the inflation rate in mind) it will be definitely lesser and because of that, it will be very difficult to calculate the return on investment correctly. Let us summarize this “how to calculate return on investment in real estate:
- Calculating the annual rent.
- Deducting the expenses from those rents. The figure obtained will be the total cash flow.
- The addition of equity builds in the cash flow.
- Dividing that net income by entire investment. The result will be the return on that property.
As an investor, one must make a diverse portfolio of investments. For example, REITs offer a higher rate of return on your investments so investing in REITs is highly recommended. Investing in high rentals areas is definitely an option you might look up to but that also needs “bigger bucks” to purchase such properties. If you do not have those “huge investments, you can buy a property in low rent areas and then refinance and rehab later. Or, you can invest in “developing areas”. Smart investors are always aware of market trends and they invest in those properties which have the potential to become high-rated properties in the future.
Another thing that you need to understand as an investor, real estate business does not offer too much if you are looking for short-term objectives. Although you can earn profit through flipping properties the margin of profit will be low. Therefore, to get better and optimal results, it is necessary that you hold your investments for longer periods, which is at least five or ten years. Even REITs offer a higher return on long term investments.
Bottom line is, real estate investment offers a higher rate of return as compared to other investment options and a diversified portfolio can not only reduces the risk factor, nut, it also increases the overall net return rate.