Investment in real estate, particularly rental properties, is one of a person’s safest investments. Your wealth will grow due to the long-term appreciation, monthly cash flow, and tax benefits of owning and running rental properties. If you’ve never done anything like this before, don’t worry—rental property investment is for everyone.
Finding the perfect property and determining whether the investment would ultimately pay off were the most difficult parts of my first property purchase when I was only 19 years old. Let’s look at the fundamentals of investing in a rental property and, in particular, how to figure out a property’s return on investment (ROI).
Return on investment (ROI) may be measured as the proportion of the equity investment total cost. The return on investment (ROI) may be calculated in two ways for real estate investments.
What Role Does Return on Investment Play in Real Estate
Determine the typical returns on a property to get an idea of your costs and if the anticipated revenue balances them in a manner that makes sense.
The cost technique and the out-of-pocket approach are the two most used ways to calculate return on investment (ROI). Listed below are simplified examples of each technique. Both examples do not consider any potential rental revenue or continuing expenditures, such as property taxes, that your property may incur.
● The Cost-Based Approach
The cost technique divides a property’s investment gain by the property’s expenditures to determine ROI.
● Out-of-Pocket Strategy
Many real estate investors prefer the out-of-pocket strategy because it provides a better return on investment. Think about making a down payment of $20,000 and taking out a loan to pay for the same home as in the preceding scenario.
How Can Real Estate Investors Get a Good ROI?
One investor’s definition of a “good” ROI may not be the same as another’s. There is a direct correlation between risk tolerance and returns when it comes to real estate investments. Conversely, more risk-averse investors may be willing to accept lesser returns in exchange for more stability.
The S&P 600’s overall yield, on the other hand, is what most investors want to match or exceed when they buy real estate. Historically, the S&P 500’s yearly return has been about 10%.
Investing in real estate does not need owning a piece of land. It is possible to diversify one’s portfolio without owning or managing any real estate by purchasing a REIT, which trades on an exchange like equities. Since REIT returns are more unpredictable than traditional real estate investments (they trade on an exchange, after all). According to the FTSE Nareit All Equity REITs index, equity REITs in the United States had an average annual return of 10.7% for the five years ending March 31, 2022. A mutual fund specializing in REITs is another option for investors.
Costs That Can Lower Your ROI
You must sell the property to receive your return on investment (ROI). It’s common for a property to fail to sell at its market value, lowering your projected return on investment.
Other fees are connected with selling real estate, such as painting and landscaping work. When calculating a property’s selling price, advertising charges, appraisal fees, and broker commissions should also be included. The property’s mortgage must also be paid off before the sale proceeds.
How Do You Pay Taxes on Rental Property When You Sell it?
If you sell an investment property and earn a profit over your cost basis, the IRS treats the difference as a capital gain. After a year of ownership, the property is subject to capital gains tax. Ordinary income is taxed at a higher rate if it is retained for less than a year and is subject to the same rules as other sources of income.
What Is the Tax Treatment of Income from Real Estate Investment Trusts?
For REITs, there are three ways to deliver income to investors: dividends, which are taxed at the regular income rate; capital gains distributions, which are taxed at a reduced capital gains rate; and capital returns, which are not taxed.
What Taxes Apply to Investment Income?
Rent received from a property you own must be reported on IRS Schedule E when you submit your taxes for the year. Additionally, you may eliminate any connected costs to arrive at your overall profit or loss on the property you’re selling for the year. Up to a specific amount, losses are not tax-deductible.
The Disadvantages of Assessing Value Only Based on ROI
The basic ROI calculation is helpful, but it doesn’t consider all of the variables that go into making a property purchase. There are a variety of ROI models to choose from if you wish to further your knowledge. To calculate a cap rate for a cash purchase, you divide your equity in a house by its expenses, which is also known as a cost technique.
As an alternative, the out-of-pocket technique may determine the return on investment (ROI). In this case, the initial cost of a $350,000 property would be $70,000 if a loan was taken out and you paid the rest yourself. Cash-on-cash return is another name for this computation.
The Final Thoughts
You may figure out how much money you’ve earned on a real estate investment by calculating your return on investment (ROI). In addition, you may use it to compare the return on real estate to other prospective investments, such as the stock market. Obtaining an exact return on your real estate investment may be more difficult if your expenses and any possible cash flow differ significantly from those shown above. Your best bet is to contact a tax specialist who is conversant with the real estate industry regulations for tax reasons.