SmartCapitalist.com

Using ROI to Compare Real Estate

Thursday, January 26, 2006
If you have ever went around looking at investment properties, you probably realize that comparing two reasonable deals is often hard to do. That is why investors in the real estate market like dealing with ratios to try to quantify the difference of one deal with another. One important ratio is the ROI or Return On Investment ratio. Which looks at how much before tax profit a property makes. This makes comparing two properties a bit easier.

ROI Example
Here is an example of how you can apply ROI to real estate to determine the yearly before tax profit. ROI is defined as Before Tax Cashflow (BTCF) over the Down Payment. This example is using numbers from a property I am looking at buying. I would be getting either an FHA loan or a piggyback loan for 5% down. Have not decided which one is the best option for my situation yet. (Or maybe some other type of financing)

$15,274 (NOI)
$11,004 less (Debt Service)
$4,270(BTCF)

ROI= $4,270(BTCF)/$7,450(Down Payment) = .57 = 57%

Now this is a pretty impressive ROI but mostly because it does not include any management costs, and I would be doing all the manual labor associated with upkeep. It also does not include a retainer that I am going to create for the potential of a rent issue such as a tenant trashing the place and just leaving, or some other issue.

ROI Conclusion
Once you compare the profit ratios, then you can start to look at how the properties differ physically. Things to look for are easy fix ups, better location, projected growth difference of neighborhoods, etc. The problem with this is that these non-quantitative variables are added on top to make it a little more difficult to decide. However you can try to factor them in on a 10 year projection of ROI or something to that effect. For instance if you could fix up a bathroom and it adds $50 a month to rent since the once drab apartment now looks nice, and it only cost $200, then that should be added in with the ROI projections. Mastering the skill of computing ROI’s and using them to compare two investment properties will help you move into a higher level of sophistication as an investor.