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Calculating the return on your investment property is an important sum to do. We wouldn’t put our money in a long term deposit at the bank without having some idea of what return they will be paying us, and property should be no different. Knowing how much you will get back and what your ROI will be will make you a smarter investor and could just lower your risk.
But how do you calculate the return on investment when it comes to property?
Before working out how much you are going to make you first need to calculate exactly how much cash you are pouring into the investment. You can’t just take into account your deposit, you also need to look at other expenses such as bank fees, solicitor fees, stamp duty etc.
Generally investors will add up all the bits of money they had to pay out of their own pocket to purchase the investment and get it up and running (to the point where it can begin generating income).
This figure is important because you need to know exactly what return you are getting ON THE MONEY YOU PUT INTO THE DEAL. You might make $10,000 from your investment but if you put $1,000,000 of your own cash into that deal then you aren’t getting a very good return. However, if you put just $1,000 into the deal then you are getting a huge return.
For our example we will be putting in a total of $30,000 to purchase a $250,000 property.
Now you need to calculate your expected investment income. This is a simple sum to do because all you need to do is assess how much rent you expect to collect from the property each week/month. Don’t worry about vacancies at this rate, we will calculate vacancies in our expenses. So simply multiply your expected weekly income by 52 to get this figure.
The example – If you were to rent your investment property for $350/week your yearly investment income would be $18,200 ($350 x 52).
You now need to calculate your annual expenses on the property. This can be tricky because you need to make sure you include EVERYTHING that you will have to pay money for. I have provided a pretty comprehensive list below, but there may be other things you need to take into account also.
To continue with our example, I will simply say that the total of all of our expenses adds up to $15,500.
OK, now what you need to do is take your total expected income and minus the total sum of ALL of your expenses.
Continuing with our example, where we were earning $350/week. We would take our entire expected income of $18,200 and minus our total expected expenses of $15,000.
$18,200 – $15,500 = $2,700
You now take the figure you just worked out above and divide that by the total amount of money you initially invested into the property.
The example – Our surplus was $2,700 so we would divide that by the $30,000 we initially put into the investment
$2,700/$30,000 = 9% Cash on Cash Return
So for our example property I am getting a 9% return on my money BEFORE we take into account capital gains. This is much better than simply putting the money into the bank. But when we take into account capital gains the figures get even more exciting
Now Adding Capital Gains
To fully realise your return on investment you need to take into account the capital gains growth you are expecting from the property. Capital gains are difficult to predict as they are driven largely by market sentiment which can be unpredictable.
A simple look at the back of a property magazine would give you the average capital gains growth over the last 5 years. You can use this figure, or simply estimate what you will be expecting.
The example – For our $250,000 property we are going to expect 5% growth in our capital gains. So our growth in the first year would be $12,500 ($250,000 x 0.05).
NOTE: Each year your amount of capital gains growth will change as the property goes up in value. For our example year 1 our property was worth $250,000 and went up in value $12,500. In year 2 our property is now worth $262,500 and if we get the same growth of 5% our property now goes up in value $13,125 ($262,500 x 0.05). This will probably be the same with rent as rents and expenses change each year.
We are almost there. You now need to take your expected capital gains growth (the dollar amount) and add it to your cash flow surplus.
The example – Our capital gains growth was $12,500 and our surplus was $2,700. Add these together and we get $15,200 (12,500 + 2,700).
This last step is easy, and it is the exciting step because you will really get to see your return on investment. Simply take your total from step #7 and divide it by your initial capital investment.
The example – Our dollar return was $15,200 when we included capital gains and our cash surplus. We take this $15,200 and divide it by our initial investment of $30,000. This gives us a whopping return of 50.67%!!! ($15,200/$30,000 x 100).
NOTE: In these calculations we have NOT taken into account the expense of paying tax. When you sell the property and access your capital gains you will have to pay tax on that growth. You will also have to pay tax on your annual cash flow surplus. We also haven’t taken into account depreciation and taxation benefits which could increase your annual surplus.
This article was taken from the web page onproperty.com.au