By Ethan Roberts
If there’s one obstacle that I’ve seen new real estate investors face time and again, it’s a lack of financial knowledge that makes it far more difficult for them to determine whether a potential purchase is a good deal or not. Because of this, novice investors often bid too high on a property and reduce their ultimate profit margin. Or they bid too low, and if there are multiple offers on the property or they’re bidding against others in an online marketplace like Auction.com, they lose the property to another investor.
So today, I want to cover the basic concept of return on investment (ROI), and how you can use it to successfully determine whether or not a real estate investment is worth making.
Estimating ROI
By definition, ROI measures the efficiency of an investment. It answers the question “Just how lucrative will this investment be?” ROI is always expressed as a percentage or a ratio, so to calculate ROI, you divide the dollar amount of the return by the total dollar amount out of pocket for the investment.
Here’s an example. I buy a home for $90,000 with cash, spend $10,000 on remodeling, and then rent it out for 12 months. My total out of pocket is thus $100,000. The rent is $1,100 per month, or $13,200 for the one-year period. What’s my ROI for that year?
To calculate, we divide $13,200 (the return), by $100,000 (the investment), so our total ROI is 13.2%, which is quite substantial.
Keep in mind that this is a gross—not net—figure, because I haven’t calculated in other likely costs that may hit during the year, such as taxes and insurance. The net ROI is more likely to be around 10% after those expenses.
With a flipped home, if you spend $200,000 total, and make a $40,000 net profit when you resell, your ROI will be $40,000 ÷ $200,000, or 20%.
If you intend to flip a home, you need to calculate your potential ROI before you make an offer on the property. You’ll need to estimate your costs in advance for expenses such as taxes, insurance, utilities, and contractor/repairmen costs. (Read this post for some tips on estimating those expenses.) You also need to have a good working knowledge of the price for which you can sell the home.
You can estimate taxes by looking up the property on your local county property appraiser’s website. Insurance costs can be estimated by calling a few insurance companies. Remember that when flipping a property, you’ll probably have to buy vacant property insurance, which is more costly than a rental home policy.
To estimate utility costs, call the local utility company and ask for the average costs for the property over the last 12 to 24 months of occupancy. Fortunately, you’ll be at the property less than those who lived there, so your costs should be much lower.
Estimating Finance Costs
The most difficult expenses to calculate in advance are the finance costs. When you flip a home, how and where you get your money from will determine these costs. There are several common options:
Hard money loans. A hard money loan is a lien on the property you’re buying. It’s the most expensive form of financing. It usually has three upfront points (3% of the loan amount) paid at closing; the interest rate is generally 12–15%. The lender may finance 65%–70% of the after-repaired value (ARV) of the home, as determined by an appraisal they will do before you make an offer.
With such a high interest rate, the faster you rehab, list, and sell the home, the greater your ROI will be. A quick flip also minimizes your taxes, insurance, utilities, and maintenance costs.
Conventional loans. Because of their higher costs, hard money loans are only recommended to those investors with lower credit scores or limited reserve funds. Investors with higher credit scores and reserves should use a conventional loan because the interest rate will only be 4–5%, with only 1–2 points on the loan.
Home equity line of credit (HELOC). The most cost-effective financing option is the home equity line of credit (HELOC), which is technically a mortgage on either your primary residence or another investment property. Banks will usually loan about 70% of the equity (current appraised value minus any loan principal still owed) you have in the property. So if you have $100,000 worth of equity in your home, you can get a HELOC for about $70,000.
The advantages of the HELOC are the low interest rate (usually prime rate + 1% or 2%), and the fact that there are usually no closing costs or points. Some banks won’t even charge for their appraisal. With the current prime rate at 3.25%, this is a very low-cost way to finance your flips.
However, there are two disadvantages to the HELOC. A HELOC has a variable interest rate, so if the Federal Reserve raises the prime rate, your interest rate will go up. The second is that the HELOC becomes a lien on the property to which it’s secured, so if you stop payments on the HELOC, the bank can foreclose on you.
Cash. Paying all cash for a home you intend to flip will return the absolute highest profit, even though the ROI percentage drops. If you pay cash, there are no points or interest to be paid, and no liens on the property. Your only “cost” is the time value of money. Time value refers to how much interest or money would have otherwise been gained during the time that you used the money to flip the home.
Now that you understand this crucial financial information, you’re well on your way to maximizing your ROI on your next flipped property—and becoming a more successful real estate investor.
Ethan Roberts is a real estate writer, editor and investor. He’s a frequent contributor to InvestorPlace.com, and his work has been featured on Money.msn.com and Reuters.com. He’s also written for SeekingAlpha.com and MarketGreenhouse.com, and was one of five contributing editors to TheTycoonReport.com. He’s been investing in real estate since 1995 and has been a Realtor since 1998. He also teaches classes on investing in residential real estate.
