Real Estate Return on Investment (ROI)

Real estate continues to yield unprecedented returns on investment (ROIs) for owners.  Calculating the ROI on a particular investment can get complicated fast.  If you are one of those who need to know the ROI down to a gnat’s eyebrow, then there are sophisticated algorithms out there you can acquire and play with to your heart’s content.

For the rest of us, getting close is good enough.  As you will soon learn, close IS good enough!

 

The Simple Truth

What most new investors miss with ROI (and I missed it, too!) is the power of leverage.  It goes like this.

Other People’s Money

Joe walks into a bank and deposits $100/week into a savings account earning 2%.  The bank lends that money out to you at 6%.  The bank is making 4% on the money.  Great.  We don't much care about that.

You buy a house and put 20% down.  You borrow the other 80% from the bank at 6%.  When the market goes up, it goes up on the total value of your house -- it goes up on your 20%, and it goes up on the 80% the bank lent you.  That 80% is yours.  You are paying interest on it.  It is this leverage where the real dollars in real estate are made.  Think of it as a margin account with an investment firm, but with the security of real estate.  Much safer, but with the potential for big returns.

In the above example with 20% down, your leverage is 5:1. For every dollar you put in, the value of the house is worth $5.  Don’t worry about the ratio of your money to the bank’s.  They’ll get paid back, and it won’t factor into the ROI calculation.

Let's go through an example for illustrative purposes.

An Example

This is a real-life example that propelled me into real estate investing.   I was living in Bend, Oregon, in the late 80s.  Californians had discovered the place and were driving prices through the roof.  (No pun intended!)  Real estate was appreciating at 18% per year!  That is unsustainable, but it was real back then.

Assume you bought a house for $100,000 in a market that was appreciating at 18% per year.  You put $10,000 down, or 10%.  That means you are leveraged 10:1 on the value of the investment (the house) versus your stake (the down payment).  Your mortgage would be $90,000.

Assume after one year, you decide to sell the home with no closing costs, mortgage buydown, taxes, or anything.  Just straight up to keep this example simple.  After one year, you sell the home for $118,000.  You pay off the $90,000 mortgage and keep $28,000.  That $28,000 includes your original $10,000 down payment plus $18,000 in profit!  That, my friend, is called a 180% Return on Investment!!!

With crazy numbers like that, I knew I didn't have to worry about secondary effects like closing costs, mortgage buydown, capital improvements, etc.  As long as they were cost-averaged over many years, they would not significantly impact the ROI.

When I realized what I had stumbled upon, I first had to check my math.  Once I confirmed the math was correct, I had to pinch myself, and then I had to figure out how to move "all in" on real estate!

Calculating ROI

To calculate the ROI, I took the rate of appreciation of the market (18% at that time) and multiplied it by the leverage factor (10:1).  18 x 10 = 180%!!!

The leverage factor is important.  It means that when the market goes up, it goes up on your money, plus the money the bank lent you.  If you put less money down, then the ROI goes up for the same market appreciation.  If you got a 3% FHA loan (33:1 leverage factor), your ROI goes off the charts!!!  It would be 594% ROI in that example above!

Guys & gals, this is pretty elementary stuff.  There aren't lots of smoke and mirrors in these numbers.

Naysayers will say I am covering over all the expenses, and that actual returns are lower.  They are right.  But not by much.  If you own real estate on average for 10+ years, then the cost-averaging of expenses washes away most impacts.  The ROI still remains elevated beyond anything else out there.

That’s why close counts!  With those kinds of returns, you can afford to give up closing costs, capital expenses, and the rest of it!  It won’t change the fact that you are still earning incredible returns on the money you invested.

All Cash

If you paid cash, well, you are at a 1:1 ratio, and your ROI is whatever the real estate market is.  Have you ever heard the investment rule “Pay cash for things that Depreciate; leverage (borrow) things that Appreciate!”

 

Another Real-Life Example

This one is my crown jewel.

By the early 2000s, my real estate had given me enough options that I could start looking to diversify into multi-family properties.  I bought a small and very old 20-unit apartment building in Chehalis, Washington, midway between Portland and Seattle.  I bought it in 2004 for $560,000.  I put down $100,000 and took a mortgage for the other $460K.

Seventeen years later, in 2021, I sold that baby for $1,600,000.  My mortgage was down to just $200,000.  I walked away with $1,400,000!!  Yes, Uncle Sam took a big chunk of that.  But I didn't care.  There was enough to go around.

If you think it was all peaches and cream, you would be wrong.  I sweated and labored mightily during some of those 17 years.  Four days after closing, the gas boiler blew up.  I almost got sued by my neighbor.  I almost got sued for discrimination by a prospective tenant.  (Long story.  Not my fault directly, but as building owner, it was still my responsibility.)  I had to put $150,000 into the foundation right before I sold.  There was more.

Bottom line: there is no way I could be a millionaire working for "da man".  I needed real estate!  What was my ROI?  I have no idea, and with that much money, I didn't care!

 

Conclusion

It is this leverage that separates real estate from stocks and mutual funds.  Stocks are rarely leveraged, and are at a 1:1 ratio.  It is this leverage that a lot of financial planners miss, and it is this leverage that creates incredible wealth and Returns on Investment.

---Peter Nelson, Founder