The world of real estate investing has many complexities that can make choosing the right strategy a challenge. Knowing how to evaluate an investment using modern metrics and analytics created specifically for the real estate market allows you to gain valuable information about a property on your radar or in your portfolio. Two metrics investors commonly use to evaluate real estate deals are return on investment (ROI) and internal rate of return (IRR). Let’s go over what these metrics are and how to calculate them so you can better understand their similarities and differences.
What Is ROI in Real Estate Investing?
Return on investment is a widely used calculation in the real estate industry. A property’s ROI measures how much it is worth today against what you paid for it originally. The outcome is a percentage of the property’s price. Calculating your ROI gives you an idea of what your profits might be on an investment property. However, ROI doesn’t consider:
- How long you hold the property.
- When you start receiving cash flow from the property.
Because ROI doesn’t account for these two important pieces of the real estate investment puzzle, you don’t get the most accurate profit or cash flow estimate. While there are no guarantees that a real estate deal will make you money, the better you understand the numbers, the more likely you are to come out ahead. If you inaccurately estimate the value of a property, it could throw your entire ROI calculation off, wreaking havoc on your budget. You can often find online tools that help you calculate your ROI, but they can’t correct mistakes in property value estimates.
How To Calculate Your ROI
Online tools are handy and make ROI calculations simple, but it’s still a good idea to know how to calculate your ROI so you understand what the number means and how you can affect it. The formula for calculating ROI is simple. It takes the amount you estimate a property will be worth when you sell it and subtracts that number from the amount you paid for it. This number is divided by the original purchase amount and multiplied by 100. The outcome is a percentage that represents the price increase of the property.
Here’s a visual of the formula:
((Investment gain − cost of investment) ÷ original value) x 100 = ROI
Here’s an example to help clarify:
Let’s say you purchase a property for $300,000 that you believe you can sell for $500,000 at some point. When we plug the numbers into the formula, we get (($500,000 − $300,000) ÷ $300,000) x 100 = 66.7%. Therefore, you can expect an ROI of more than 60% on your $300,000 investment. The calculation is simple, which is why it’s so popular, but the downside is that it leaves a lot out. ROI calculations assume you’re buying and selling within a short period.
What Is IRR in Real Estate Investing?
Internal rate of return is a little more complex than ROI, making it the less preferred method of calculating potential gains on a real estate investment. However, IRR can give you a more accurate picture of what to expect when you sell a property because it takes into consideration the length of time you own a property. A real estate investment’s IRR is based on the value of the property during each period you own it. Using this calculation provides you with data on your gains over the long term.
Seeing your gains annualized allows you to determine if a property is worth holding for rental income or if you should sell it for capital gains you can roll over into another investment property. Because ROI doesn’t take the time you hold a property into consideration, you don’t know how effective your dollars are over an extended period. With IRR, you can evaluate how well each dollar you spend on a property works for you in the form of gains over time.
How To Calculate Your IRR
You can use a spreadsheet to help you calculate the IRR on your investment. This equation is a bit more complex than the calculation for ROI, but it’s still good to know how to use it to determine your potential for gains and avoid losses. You’ll use a series of formulas since this method of calculation breaks down payments and income into regular monthly or annual installments.
Here’s what the formula looks like:
IRR = (future value ÷ present value) ^ (1 ÷ number of periods) − 1
It might also be represented in the following ways:
0 = NPV SIGMA CF n ÷ (1 + IRR) ^ n
0 = CF t = 0 + [CF t = 1 ÷ (1 + IRR)] + [CF t = 2 ÷ (1 + IRR) ^ 2] + … + [CF t = n ÷ (1 + IRR) ^ n]
The last formula from the list above demonstrates how the calculation is done for each period you own the property.
Differences and Similarities Between IRR and ROI
The main difference between IRR and ROI is that an IRR calculation considers the time value of money, whereas ROI doesn’t. This means IRR can provide a more accurate estimate of how valuable a piece of property is and what it brings to your investment portfolio. Calculating IRR is more complex than ROI, so some investors avoid using it. The IRR metric tells you what cash flow you need to make each period to get the property’s value above your original investment.
Both IRR and ROI calculations help you understand your potential for returns on an investment property. Investors need to use all of the tools available to them if they want to have a firm grasp on what to expect from their real estate deals.
Get Expert Advice on Real Estate Investing
When you know how to calculate the ROI and IRR on an investment property, you’re better equipped to understand how it can affect your portfolio now and in the future. If you need help with real estate investing, the professionals at Titan Funding in the Boca Raton, Florida, area can help. We have years of experience working with clients, advising them on what they can do to grow their portfolios.