When people ask me about the return on investment (ROI) for real estate, they often balk when I respond that I aim for 15–30% returns. But I’m getting ahead of myself.
There are many ways to measure ROI on real estate investments. As an investor, you should understand all of them — or at least the ones relevant to your investment strategy.
You should also understand how different types of real estate investments have historically performed. What is a good ROI on a rental property? On a real estate syndication investment? What about returns on real estate crowdfunding investments?
Read on for the next five minutes, and you’ll have a far better grasp of real estate returns on investment.
- Real estate returns come in two main forms: income yield and profits from appreciation.
- Alternatively, you can invest debt secured by real estate, which pays interest.
- Returns on real estate investments historically equal or surpass stock returns.
- A high return on investment doesn’t always come with high risk (although it can).
What Is ROI in Real Estate?
When you invest money, you expect to earn a return on your investment. In real estate, those returns come in several forms.
First and foremost, bear in mind that you can invest by owning real estate — an equity investment — or in debt secured by real estate.
Real estate debt investments include mortgage REITs (mREITs), debt crowdfunding investments, private notes, and secured debt funds. These typically pay returns as interest, although mREITs pay a portion of their profits.
Equity real estate investments include buying rental properties directly, or equity crowdfunding investments, or equity REITs, or most real estate syndication investments. These usually pay both ongoing income and profits upon sale.
Investors typically measure income yield by cash-on-cash return. This calculates the annual income you collect over the total cash you invested. For example, if you earn $800 this year on a $10,000 investment, you earned a cash-on-cash return of 8%. Simple enough, right?
Properties also appreciate over time. Even as you collect cash flow, the property also rises in value. That same property that paid 8% cash-on-cash return might have also risen in value by 4% that year, for a total annual return of 12%.
Real estate investors measure annualized returns in several ways.
Appreciation looks great on paper, but you don’t actually collect those profits until the property sells. So you might earn a 4–8% income yield for the first five years you own a property, then a 50% profit when it sells at the end of that time. How do you measure that as an annual return?
The easiest way to calculate it is with a simple average. If you earned a 60% total return (including both income and profits) on a property you owned for five years, that comes to a 12% average annual return (60% / 5 years = 12%).
But if you had actually collected the full 12% in returns each year, you would have been able to reinvest that money for compounding returns. So, investors take compounding into account by calculating an investment’s internal rate of return (IRR). It’s the annualized return, calculated as if you’d been able to reinvest each year’s returns along the way. The formula is complex and you can’t do that math on the back of a napkin, so use our free IRR calculator to run the numbers on any investment.
Lastly, you might see that some real estate syndications offer a “preferred return.” That protects you as a passive investor by giving your returns (up to that percentage) higher priority than the general partner or sponsor. When the property sells and profits get divvied up, you get paid out that return before the sponsor can take any returns for themselves.
For more information, read up on real estate investing terms here.
Deni and I love to talk about infinite returns on real estate investments — a confusing concept for many new investors.
In math, any return on a $0 investment represents an infinite return on investment. But, even though it’s possible to buy a rental property with no money down, you still have closing costs, right?
With rental properties, you can achieve infinite returns using the BRRRR method. It stands for buy, renovate, rent, refinance, repeat: you buy a fixer-upper, renovate it, and then instead of selling it as a flip you refinance it to keep as a rental property. When you refinance it, you can potentially pull your initial down payment and closing costs back out, assuming you created enough equity with your renovations. That leaves you with $0 of your own money invested, even as the property generates cash flow and appreciates for you over time. Those returns represent an infinite return on your $0 investment.
You can also achieve infinite returns on real estate syndications. It works the same way, simply on a larger scale: the sponsor renovates the property and refinances it, returning passive investors’ capital back to them. As passive investors, we get our money back but we keep our ownership interest in the property.
This model lets you keep reinvesting the same capital over and over again, letting it generate enormous returns over time.
Real Estate ROI Formulas
For cash-on-cash (CoC) returns, simply divide your annual income from an investment over the total amount you invested:
Cash-on-Cash Return = Annual Income / Total Cash Invested
Cash-on-cash returns are specific to you and your financing terms. If you want to calculate a property’s capitalization rate (cap rate), which ignores financing and just looks at the property’s cost, simply divide the annual net operating income (NOI) over the purchase price:
Cap Rate = Annual NOI / Purchase Price
Net operating income refers to the rental income minus any operating expenses such as property management fees, insurance premiums, property taxes, vacancy rate, and repairs or maintenance. It does not include debt service.
For average annual returns, you just take a mathematical average of the total returns (including both income and profits) divided by the number of years you held the property:
Average Annual Return = Total Returns / Years Owned
For example, say you invest in a passive real estate syndication with $10,000. It pays $400 in cash-on-cash returns over the first year, $500 in the second year, and $600 in the third year. At the end of three years, the sponsor sells the property and you get $13,000 back (your original $10,000 plus $3,000 in profits). You earned $4,500 in total returns over the course of three years, for an average annual return of 15%.