How to Calculate Return on Investment (ROI)

Today, I thought I'd share how I calculate return on investment or ROI. This is sometimes also called the cash on cash return because it is a measure of the rate of return on the money you actually invest in a property, business or any other revenue generating asset for that matter.

First, why is it important to know the ROI of an investment? In earlier posts, I talked about the most basic form of comparison between properties, the CAP rate. This is a snap shot of the rate of return based on the purchase price of a property. The ROI is a snap shot of the rate of return on your cash invested. Two properties with similar CAP rates can produce very different ROIs based on a number of factors like: amount of financing available, interest rates, soft costs like legal, survey and accounting costs, etc. Calculating the ROI gives you a picture of how hard your money is working for you.

So let's look at an very simple example for illustration. Let's say you are considering a building valued at $1,000,000. There is a tenant in place paying $100,000 per year in net rent - meaning that all of the expenses of operation for the property are borne by the tenant in this example - a 10% CAP rate. For illustration, let's say that the downpayment, in this scenario, is 35% of the purchase price or $350,000. That leaves a mortgage of $650,000 to be paid for out of the net rent recieved from the tenant.

A mortgage of $650,000 at 6% would cost about $55,550 annually. Next take the net rent recieved annually and deduct the mortgage costs to arrive at a net cash flow. $100,000-55,550=$44,450. The final step is to calculate the rate of return on the initial investment by dividing the cash flow by the initial investment. $44,550/$350,000=12.73%

This is an extreme example, and I wouldn't expect most investments to kick out 12.73% on an annual basis. In fact this one probably wouldn't either - we didn't consider other costs like lending expenses, land transfer tax, etc. that would affect the actual initial investment.

What's the power of this measurement? You can fairly quickly get an idea of the return on your cash investment over several properties and even across asset classes without relying solely on a comparison of purchase prices related to initial income. Powerful stuff indeed.


return on investment August 7, 2009 at 12:57 AM  

According to me money has become necessity in today's life. Money making is the only goal of the business houses. Let's check out some ways of money making, such as first of all you should have target in your mind and have some stronger belief to achieve that. Always try to create some extra income, invest after proper research and diversify your investment and try to reduce the use of cc, so you can save money. Always invest with awareness and great sense. For more details on return on investment refer return on investment

Doug Lytle August 7, 2009 at 9:35 AM  

Thanks for contributing! I couldn't agree more - you need to have a target in mind and always look for ways to increase cash flow. A new service for your tenants, who are your customers after all, or a more efficient mechanical system can really drive long term success and increase your bottom line.

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