Real Estate Investing – Calculating ROI

One of the commonly touted advantage of real estate investing is the financial leverage that can result in enormous return on investment. A typical example usually compares investing an amount in real estate versus the stock market, where the return on investment for real estate investing far exceeds that of the stock market.

Photo by Brian W. Ogilvie via Flickr

For instance:

Description	Real Estate	Stock
1. Initial value	$100,000	$100,000
2. Amount invested	$5,000	$100,000
3. Mortgage or margin amount	$95,000	$0
4. Mortgage or margin interest	6%	0%
5. Projected annual growth	5%	8%
6. Projected value in 10 years	$155,000	$200,000
7. Projected profit	$55,000	$100,000
8. Projected return on invested capital	1,100%	100%

Real Estate Investing Provides Greater Financial Leverage and Return On Investment (ROI)

It’s possible to start with less capital investing in real estate because you could take out a mortgage; whereas buying $100,000 worth of stocks require $100,000 (ignoring some of the leveraged investment vehicles and margin account). After 10 years, real estate investment might appreciates to $155,000 and net you a profit of $55,000 (line 6 minus line 1), whereas stock market investment might appreciates to $200,000 and net you a profit of $100,000. However, the return on investment, or ROI, for real estate investment is 1,100% compares to only 100% for stock market investment.

But the example left out a few important details

Unfortunately, this comparison is not an apple-to-apple comparison — it ignores the cost of owning these investments for 10 years. For stock investment we could say it’s negligible and is already built into the projected annual growth. However, it’s not so simple with real estate investment, because there are significant costs that must be considered:

• Closing costs as a buyer, and then later as a seller
• Mortgage principal payments
• Mortgage interest payments
• Private mortgage insurance (if any)
• Property taxes
• Home insurance
• Home improvement
• Repair and maintenance
• Other costs associated with running a rental business

Which may be offset by:

• Rental income
• Depreciation
• Tax deductions

If the property is not an investment property — i.e., primary residence — then the costs and benefits must roughly equal to the cost of renting in a similar situation. Another factor is the 1997 Taxpayer Relief Act allows individuals to exclude up to $250,000 ($500,000 for couples) of the capital gain on the sales of their primary residence.

So the next time you hear about a great opportunity in real estate investing with ROI numbers in the thousands range, be sure to take all these factors into consideration.

What others are saying about real estate investing financial leverage:

• Is Real Estate Investing Profitable? at I’ve Paid For This Twice Already…
• The Fallacy of Return on Investment at Quest For Four Pillars
• Is David Bach’s Math Misleading? at Money, Matter, and More Musings
• Stocks Vs Real Estate, Winning Investment Strategies at The Digerati Life
• Top 4 Don’ts in Using Real Estate Leverage at About.com
• Real Estate Leverage at Peter Pays Paul