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Thursday, February 3, 2011

Calculating your return on real estate investments

Calculating return on real estate investments at its most fundamental level involves subtracting all the costs paid into a property from both revenue earned during the term of ownership in addition to selling price. Subtracting the buying price from the selling price is simply not an accurate way to determine real estate return because there are so many underlying benefits and costs associated with property ownership that occur on an annual basis.

In other words, real estate investing is complicated by the myriad of revenue and cost sources incurred over the term of ownership. Furthermore, in the case of real estate investment groups, and property managers, calculating return on investment is more of an annual than end game operation making profitability, and debt calculations in the form of percentages and ratios rather than simple positive or negative numerical amounts quite relevant in the assessment of return on investment.

To simplify the return on investment a good approach can involve staying organized throughout the whole investment process from start to finish while simultaneously utilizing the numerous techniques and tools involved in assessing return on investment. This means keeping track of and recording every dollar and cent put into the property and every dollar and cent returned in the form of capital gains, and tax benefits. The following sections break down the property investment process into the fundamental units of revenue, cost and techniques that can assist in the calculation and assessment of return involving the revenue and costs from the sections below.

Sources of property revenue and expense


The sources of property revenue tend to less than the numerous costs and expenses that a property can incur. For this reason it is quite vital to maximize and optimize the potential revenue of a real estate investment in order to make it worthwhile. Two lists comprised of both the source of property revenue and expense are listed as follows:

1. Source of property revenue


• Capital gains (after deduction of overhead if applicable): "Profit" on the sale of the property as calculated in terms of purchase price.
• Rental income: Income earned through lease, rental or use of space by a third party.
• Tax deductions: Tax savings such as mortgage interest,
• Tax Credits: Additional tax savings such as renovation credits

2. Sources of property expense


• Original settlement costs of real estate: All costs associated with purchase of property
• All maintenance and renovation expenses: Upkeep, repair and remodeling.
• Operating expenses/Overhead (if not deducted from capital gains): Utilities
• Total ammortized interest payments at time of sale: The sum of total interest payments
• Tax on Capital gains: Government tax incurred from profit on the sale of property
• Hazard Insurance: Protects against losses from unforeseen events
• Mortgage Insurance: Premium paid as a protection feature should the real estate enter default or foreclosure. (this expense can be avoided in some cases)
• Government Recapture tax (If applicable): Tax associated with sale of property financed by Government sources.
• Back end expenses associated with sale of property: All costs associated with sale of a property.
•Opportunity cost (if applicable): The potential loss of profit due to fixed nature of property investment i.e. loss of revenue from missing a more profitable investment
• Inflation: The cost of inflation is also an expense as this can amount to approximately 2-3% of the total value of a property per year.

As evident from the above list, there can be many more sources of expense than profit from a property investment which hints at the necessity for fiscal prudence and keen judgment when purchasing property. When purchasing a property it may be helpful to forecast and estimate the total costs of the property purchase and estimated market value of the property at a future time to assess whether or not the investment will be profitable. It can be easy to overlook some of the many expenses and costs that go to into a property making the purchase and sale prices of property somewhat inaccurate measures of the profitability of the real estate.

In essence, calculating the return on real estate investments is a numerical balancing act combined with market forces, and investment savvy. Knowing the dynamics of the real estate market, trends, property factors such as upkeep, maintenance and renovation expenses etc. are all important to turning a profit in addition to optimizing as many of the possible benefits of property as possible. The benefits of property ownership include all sources of savings, expense reduction, income and capital gain that can be squeezed out of a property.

Tips and techniques to consider in calculating return on real estate investment


One of the most opportune times to calculate the return on real estate is before it actually happens in the form of a property profile. In other words, assessing all the potential advantages and disadvantages before the property is even purchased can not only help in future calculation of return on investment, but also the front end costs. The tips below can help with the calculation of and the forecasting of return on real estate investment.

• Develop a bookkeeping system
• Utilize Investment return equations in forecasting return
• Investigate all tax implications, costs, and benefits
• Assess market conditions and real estate potential
• Optimize property income
• Reduce costs

Return on investment equations and software


When forecasting and calculating annual rather than total end profits on real estate, numerical equations and software tools can be used to calculate return on investment. These tools can be especially useful amidst business property investments within fluctuating market conditions. In other words these tools help organize the many variables of property management into orderly numerical functions that provide quick and accurate answers provided the input numbers are correct. A few examples of such equations are listed below:

• Debt Coverage Ratio: Operating Income/Mortgage costs (associatedcontent, Butler)
This equation measures annual income as a percentage of cost. A division ratio that assesses profitability in terms of a ratio result rather than percentage amount. Also useful in assessing debt.

• Capitalization Rate Valuation: Net income before mortgage expenses including operating expenses/Capitalization Rate i.e. annual percentage rate of return(ezine.com, S.Gillman) Helps assess overall property value in terms of annual income before mortgages expenses are deducted.

• Total Yield: Annual Income/Sales Price (associatedcontent.com, Butler)
Measures annual income as a percentage of sales price and therefore does not include expenses and costs.

• Cash on Cash Return: Annual Income after mortgage costs/ Downpayment (associatedcontent.com, Butler) Provides an annual estimate return on initial investment after costs and is good for assessing real estate investment risk and opportunity cost.

There are also several software packages and online tools that can be utilized to calculate annual returns on real estate investment. It can be a good idea to have a strong understanding of the big picture when utilizing such tools because the tools themselves only measure isolated circumstances of revenue and cost variables.

In other words, in order to acquire an accurate assessment of return one must 1) enter the correct input variables and 2) correctly sum and utilize the outcome of all applicable equations. That is to say estimated income and credibility of the equations should be sound. The more such equations are used, the more complete the overall return on investment assessment is likely to be. An example of a free online real estate return calculator can be found at the following link.


To summarize the above, calculating return on real estate revenue is essentially a simple task. However, this simple task is complicated by the multiple and ongoing costs and sources of cost reduction associated with the ownership of a property. For this reason, sound bookkeeping and awareness of all the variables can be of great benefit to accurately assessing the real return on a property.

The many costs and expenses of property are sometimes overlooked when making the investment return calculation in addition to overlooking the potential reductions to capital gains such as maintenance costs and environmentally friendly renovations that may incur a significant tax credit translatable into gain from ownership of property before the property is even sold.

Sources:

1. http://athenianloans.com/Tax_Effects.html
2. http://www.HousesUnderFiftyThousand.com/due-diligence-checklist.html
3. http://ezinearticles.com/?Say-Goodbye-To-The-Gross-Rent-Multiplier&id=303508
4. http://www.associatedcontent.com/article/27644/calculate_the_return_on_your_real_estate.html?page=3
5. http://www.community-newspapers.com/archives/lgwt/20060222/lgperkins.shtml