Return On Investment (ROI) – measures the profitability of an investment or asset purchase decision. If calculated correctly, the ROI can simply reveal the efficiency of an investment as well as compare the efficiency of a number of different investments.
Determining the return on investment is a very important part of any investment review.
The most common ROI analysis compares investment returns and costs or expenses resulting in a ratio, or percentage. In cases where the resulting ROI ratio is greater than 0 (or a percentage greater than 0%) signifies that the investment returns more than its cost.
In order to calculate an investment’s ROI the following financial information will need to be incorporated:
- Initial up-front costs associated with the investment
- Property purchase price
- Closing Costs
- Mortgage expenses
- Maintenance Cost
- Time – how much time will you spend on this property? Time equals money
- Annual Operational expenses
- Annual interest expense
- Annual rental
- Anticipated capital gains
- Time – expected time frame for return to happen
- Investor tax rate information
- Other Income
- Chronological Time Line
- Time frame – When do you expect returns to happen?
- Create a timeline and lists all returns (positive figures) and expenses (negative figures)
- Establish a correlation between the projected returns and expenses
We can follow these steps by calculating the Annualized Return on Investment
Assuming an investment transaction took place on January 1, 2011. That investment cost you $100,000 including fees. Today, September 21, 2011, you decide to sell that investment and you receive $120,000 after all expenses.
Now we want to find the annualized return on investment of this property so we can compare it to other investments. In finance, this is often known as calculating your internal rate of return. Technically, this process involves determining a discount rate at which the present value of a series of investments is equal to the present value of the returns on those investments.
For a simple situation like the example above:
Annualized Return on Investment = (Final return/Initial investment)^(365/days) – 1
This indicates that the annualized return on investment equals the final dollar amount divided by the initial investment (positive number for this equation) raised to 365 divided by the number of days the investment took to complete. Then you subtract one from the number you just calculated and multiple by 100 to get your percent.
This is a simple example, but keep in mind that every investment is different and there may be other factors affecting or affecting the process.
ROI calculations can be used to compare investments. When more than one investment is compared, and when factors between the alternatives are truly equal, the investment with the higher ROI is considered the better option. A high ROI is determined when investment gains compare favorably to investment costs.
It is important to keep in mind that there are factors and risks that can influence the outcome of the ROI such as investor’s income tax brackets, capital gains rates and recapture depreciation tax rates since they impact return on investment. For that reason, an effective analysis of an investment will measure the probabilities of different ROI outcomes, and astute investors will consider both the outcome of an ROI calculation and the risks that go with it.
There are ways to possibly improve the ROI by reducing costs, increasing gains, or accelerating gains. Some factors can be:
- Increase after tax cash flows for income property by reducing operational costs and increasing rents
- Minimizing vacancies and making sure that rental rates are at market value
- Periodically review the market to see if rental rates reflect current market conditions