The cost method and the out-of-pocket method are two important ways to calculate Return on investment (ROI), a measurement of how much money, or profit, you have earned on real estate investments as a percentage of its total cost.
Key Takeaways
- Return on investment (ROI) measures the profit you have made (or could make if you were to sell) on an investment.
- ROI is calculated by comparing the amount you have invested in the property, including the initial purchase price plus any further costs, to its current value.
- Two common ways of calculating the ROI on a real estate investment are the cost method and the out-of-pocket method.
2 Ways to Calculate Your Return on Investment (ROI)
There are two primary methods for calculating ROI: the cost method and the out-of-pocket method. Following are simplified examples of each method. Note that neither example accounts for any rental income your property might produce or any ongoing costs, such as property taxes.
The Cost Method
The cost method calculates ROI by dividing the investment gain in a property by that property's initial costs.
As an example, assume you bought a property for $100,000 in all cash. After repairs and improvements, which cost you an additional $50,000, the property is valued at $200,000.
This makes your gain in the property $50,000 (i.e., $100,00 gain in market value less $50,000 spent on costs).
To use the cost method, divide the gain by all the costs related to the purchase, repairs, and rehabilitation of the property.
Your ROI, in this instance, is:
$50,000 ÷ $150,000 = 0.33, or 33%.
The Out-of-Pocket Method
The out-of-pocket method is preferred by many real estate investors because it results in a higher ROI. It takes the current equity of the home divided by the current market value. Note that this differs from the above calculation where the cost method divides the investment gain (not the equity) by the initial total costs (not the market value).
Using the numbers from the example above, assume you bought the same property for the same price, but this time, you financed the purchase with a loan and a down payment of $20,000.
Your out-of-pocket expense is $20,000 plus the $50,000 for repairs and rehab, for a total of $70,000. With the value of the property at $200,000, your equity position, or potential profit, is $130,000.
Your ROI in this case is:
$130,000 ÷ $200,000 = 0.65, or 65%.
This is almost double the first example's ROI. The difference, of course, is attributable to the loan: leverage as a means of increasing ROI.
What Is a Good Return on Investment for Real Estate Investors?
What one investor considers a "good" ROI may be unacceptable to another. A good ROI on real estate varies by risk tolerance—the more risk you're willing to take, the higher ROI you might expect. Conversely, risk-averse investors may happily settle for lower ROIs in exchange for more certainty.
In general, however, to make real estate investing worthwhile, many investors aim for returns that match or exceed the average returns on a major stock market index such as the . Historically, the average annual return on the S&P 500 is about 10%.
Of course, you don't have to buy physical property to invest in real estate. Real estate investment trusts (REITs) trade like stocks on an exchange, and they can provide diversification without the need to own and manage any property. In general, REIT returns are more volatile than physical property (they trade on an exchange, after all). Equity REITs delivered five and 10-year compound annual returns of 3.45% and 6.59%, respectively, for the period ending March 31, 2024, as measured by the FTSE Nareit All Equity REITs index. You can also invest in REITs through mutual funds that specialize in them.
Mortgage lending discrimination is illegal. If you think you've been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report with the Consumer Financial Protection Bureau or the U.S. Department of Housing and Urban Development.
Costs That Can Reduce Your Return on Investment
In order to realize your ROI in actual cash profits, you have to sell the property. Often, a property will not sell at its market value, which will reduce your expected ROI if that was the number you based your calculations on.
In addition, there are costs associated with selling real estate, such as repairs, painting, and landscaping. The cost of advertising the property should also be added in, along with appraisal costs and the commission to any real estate agent or broker that's involved. And, of course, if there's a mortgage on the property it must be paid off.
How Is Investment Real Estate Taxed When You Sell the Property?
When you sell investment property, any profit you make over your adjusted cost basis is considered a capital gain for tax purposes. If you held the property for a year or more it will be taxed at capital gains rates. If you held it for less than a year it will be taxed as ordinary income, which will generally mean a higher tax rate, depending on how much other income you have.
How Is Income From a Real Estate Investment Trust (REIT) Taxed?
Real estate investment trusts, or REITs, can pay income to their investors in three forms: dividends, which are taxable at the same rate as ordinary income; capital gains distributions, which are taxed at the usually lower rate for capital gains; and returns of capital, which are not taxable.
How Is Rental Income Taxed?
If you have rental income from a property you own, you have to report that income when you file your taxes for the year, generally on IRS Schedule E. You can also subtract your related expenses to arrive at your total income or loss on that property for the year. Losses are deductible up to certain limits.
The Bottom Line
Calculating your ROI is a way to determine how much profit (if any) you have made on a real estate investment. You can also use it to compare the return on real estate to other potential investments, such as stocks. The examples above are simplified for the purposes of illustration, and, depending on all of the costs involved and any potential cash flow you receive from your real estate investment, getting a precise ROI may be more complicated. For tax purposes, in particular, you will most likely want to consult an accountant or other tax professional who is familiar with the rules as they apply to real estate.
