What is ROI and why is it Important in Real Estate?

Return on investment, or simply ROI, is widely used in business and financial circles. It is not only used “behind the hood” for analytics — the term is heavily used for marketing purposes as well. Virtually every single real estate or business project trying to attract funds presents its projected return on investment figures. 

It would be a mistake to think of this metric as simply a marketing ploy. ROI in full form is a crucial tool for any investor and entrepreneur, regardless of industry. But to calculate, interpret and use it, you must understand the concept behind it. 

What Does Return on Investment Mean?

ROI meaning in finance is pretty straightforward — it shows how many dollars of profit are generated by every dollar invested (expended). It is a basic metric that shows how efficient it is to invest in a certain real estate asset, business project, stock, etc.

ROI is key to the decision-making process - all other metrics, indicators, and considerations supplement it. Still, the ratio between expenses and income is always at the core of any opportunity evaluation.

This metric is applied almost universally—in real estate, investments, marketing, business, manufacturing, retail, and other industries. The formula is sometimes altered to suit the industry or type of projects better, but the basics persist.

So, let’s take a look at what is ROI and how you can use it to manage your real estate and other investments.

ROI Formula and Calculation

Since ROI is the ratio of income to investments, the formula is self-explanatory:

ROI = (Net Income / Total Investment Cost) x 100

How to Calculate ROI

The formula itself is rather simple, and it is hard to mess up the math. If a $5000 of expenses give you $500, the ROI is 10%. Easy, right? But correctly calculating the ROI formula's variables is often tricky. 

First, net income should always be used: revenue minus taxes, loan interest, and other expenses. Using gross income instead is either an error (when you do it for your own calculations) or a very basic manipulation by scammers.

Second, people often underestimate their investments, taking the initial expenses into account but forgetting ongoing costs, including marketing and maintenance, is a surprisingly common error.

How Can You Supplement ROI?

Although ROI is an extremely useful and important indicator, it isn’t all-encompassing. Liquidity, risks and some other factors are completely outside the ROI scope, and even including time as a factor requires some modifications to the metric.

Multiple altered versions of the ROI formula have been developed to better suit specific situations and requirements. The use of other indicators and analysis methods is also crucial for selecting the most profitable opportunity.

Modified ROI Formulas

Three modifications of the formula stand out in popularity among investors worldwide.

The first variation looks as follows:ROI = (Net Income – Initial Investment) / Initial Investment x 100 

Its primary use case is to compare options when the ongoing costs of two or more options are either negligible or similar.

The second variation focuses on the value of an investment instead of income generated:

ROI = (Final Value of Investment – Initial Investment) / Initial Investment x 100

It is mostly used when the goal is not to get a stable flow of income, but to make a one-time profit. A good example would be a resale of property after renovation.

Taking time into account is much trickier in most cases. If ongoing expenses are negligible, simple multiplication is possible. For instance, if you have a quarterly ROI of 4%, you just need to multiply it by 4 to get your annual ROI (16% in this case). But usually, ongoing expenses are present, so the formula becomes much more complicated:

ROI =( Net Income x TimeInitial Investment + (Ongoing Costs x Time) x 100) x Time

Correctly comparing opportunities requires using the same timeframe for all of them. Otherwise, the correct data wouldn’t be possible to obtain.

ROI Alternatives

Many alternative indicators supplement or entirely replace ROI for analytics in certain industries. The common alternatives include ROAS (Return on Advertising Spend), IRR (Internal Rate of Return), and NPV (Net Present Value).

Examples of ROI Calculations

To illustrate how ROI calculations work, we’ve prepared a couple of model examples from different approaches to real estate.

Rental Business

Let’s assume you purchase a rental asset for $200,000 with closing costs of $10,000. You rent it out for $3,000 a month and have ongoing expenses of $15,000 annually. 

Net annual Income would be $3,000 x 12 - $15,000 = $21,000

Total investment equals to $200,000 + $10,000 = $210.000

So the result would look like this:

ROI = ($21,000 / $210.000) x 100 = 10%

Real Estate Investment

Let’s assume you buy a house for $300,000, invest $50,000 in renovation, and sell it for $400,000. Another assumption is that real estate agents charge 5% of the sale price ($20,000). We would have to use a variation of the formula: the one focused on investment value.

The initial investment is purchase price minus renovation expenses, or $350,000. The final value is $380,000 (sale price minus the agent’s fee).

So the result would look like this:

ROI = ($380,000 – $350,000) / $350,000 x 100 = 8.57%

Naturally, both examples above are extremely simplified. Typically, a lot more different expenses must be added up, and the math isn’t that straightforward. But they clearly illustrate the model.

Conclusion

ROI is among the key tools in any real estate investor’s arsenal. It can’t be relied upon as the sole metric, since it leaves out many factors influencing a project's potential profitability, so your analysis shouldn’t rely solely on ROI. But it forms the basis for initial evaluation and comparison of available opportunities. 

Moreover, it would be wise not to accept any ROI figure at face value. Understanding what specific variation of the ROI formula was applied and how the variables were formed is necessary to know if the ROI value is legitimate. Specialized software like Mindall CRM effectively resolves the issue—it enables you to easily track all expenses of your real estate business and provides accurate data for calculations.