Return on Real Estate Investments
Definition and caculation
What does real estate return mean?
The goal of every financial investment is a reasonable return. If the return on capital is put in relation to the costs incurred, the return on the investment is calculated. The driving factor behind a personal real estate investment is in rent savings or the generation of rental income. The personal use of a house or an apartment promises a high emotional return such as independence and well-being. The actual profitability of properties must be assessed by an exact calculation of the return.
ROI of Rental Property
Whether it is economically worthwhile to buy a house is based on the capital expenditure, the purchase price and a sustainably attainable rental income. Every investor should be informed about the housing market, the rent index and the rental return that can be realized in the neighbourhood. For the calculation, the achievable annual rent is required. This is the basic rent without utility costs such as hot water and heating expenses. The annual rent is dependent on the current housing situation, the housing market, location, size and equipment of the property and other regional determinants.
Return through Sales Profits (Capital Gains)
With real estate to rent out a reasonable return can also be achieved through the price. If the owner of a property sells it above its purchase price, there will be a surplus that will be set in relation to the duration of the possession. The return of the sale is calculated through the difference between the acquisition price and sale proceeds. The acquisition costs also include all acquisition costs, subsequent costs for installation and maintenance as well as advertising costs relating to the sale. When determining the sales return, the tax on the sales proceeds must also be taken into account. Private investors enjoy the advantage that the sale of their rented house or rented property is generally exempt of taxes for up to 10 years. If they lived in the property themselves or accommodated it in the year of the sale, including the two years prior to the sale, the sale remains tax-exempt.
How to Calculate the ROI of Rental Property
Very few individuals purchase several real estate properties in their lifetime, so the real estate purchase or construction is to be well thought-out. The calculation of the annual return of a real estate investment is necessary in order to assess whether the acquisition of a house or flat is economically viable. How much can the purchase price be so that the investment pays off for the investor? In order to be able to compare properties with shares and bonds, the return calculation is a must.
The property’s gross rent return is calculated with the quotient of the gross annual rent and the investment costs of the property.
- Example: If a flat’s gross rent is € 6,000 and the purchase price is € 120,000, the gross rent return is 5%. The gross rent return is often advertised in real estate purchases, but this does not give much of an indication, since it ignores important cost positions and the risk of vacancy.
The investment costs include the purchase price, the building costs for new properties and also the ancillary acquisition costs of at least 10 %. The acquisition costs include the land transfer tax, fees for the real estate agent as well as notary and registration charges in the land register. In order to determine the actual annual income for the investor, one has to deduct the administrative and maintenance costs per year from the gross rent. The costs for maintenance depend on the use, the age and the condition of the property. A guideline used for maintenance and repair costs is the following: € 6 to € 14 per m² of living space and year or a flat rate of 20 % of the annual rent.
- Example: The net annual return amounts to € 5,560 with a presumed € 300 administrative costs per year, € 8 maintenance costs for 55 m² and € 132,000 investment costs. A vacancy risk of 2 % of the gross annual rent is to be deducted, which means that an annual income of € 5,440 is calculated. This amounts to a net rental return of 4.1 %.
The net rental return is more significant than the gross rental return and can serve as a benchmark for other asset classes. It is the return on which the capital invested in the property bears interest, after the deduction of all real estate costs before tax. Conclusion of the calculation:
- The lower the costs and the higher the rental income, the better the return;
- The lower the purchase price (and the worse the location), the higher the return;
- The better the location of the property (high purchase price), the lower the return.
This means that the net rental return cannot be a sufficient foundation for a qualified investment decision. Up until now, the financing structure for the acquisition of the real estate property and its taxation has been completely ignored in determining the return. If the investor uses loan capital in the form of a building loan, the return on the equity capital can be calculated as follows:
- In our example, a building loan with 2 % interest has been paid out for € 50,000. The borrower has to pay an annual interest of € 1,000. In this case, the net result is € 4,440. The basis for the calculation of the return is now only the input of equity: (€ 4.440 / € 70,000 x 100) = 6.3 % return.
Thus, the equity return is 2.2 % higher than the net rental return. If the equity of the investor is further reduced, for example, to € 40,000, the calculation looks as follows: The interest on the loan amounts to € 1,600 and therefore the net profit equals € 3,840. With a real estate loan of € 80,000, the return amounts to 9.6 %! This is also referred to as the leverage effect of the return by an increased use of leverage.
Side note: The multiplier
The multiplier is the present-value factor for the return capitalization. In the case of the value-based method, the real-estate valuation can be carried out using the multiplier. Using the multiplier factor, a simple return calculation can also be performed: 100 / factor = return. The multiplier factor is calculated in two ways: purchase price / net rental return or 100 / gross rental return.
For our example, this results in a factor of 20. This makes it easier to specify the market value of a property. The multiplier factor indicates that the sample property costs 20 times the annual rental income. However, this calculation is greatly simplified. The property value, the property rate, the remaining useful life of the building and the raw rental return minus the management costs (net return) are offset in the value-based method. The simplified calculation is sufficient as a guide for the market value of different properties in different locations. However, the property choice should be made on the basis of in-depth analysis of the profitability, the attainable return or the sales proceeds.
When real estate is acquired as a capital investment, there are many ways to save taxes. First of all, the income from the lease must be subject to taxation with the personal tax rate. The owner of a rented property can get some expenses recognized as tax relevant. For example, the following cost items can be deducted from tax:
- Acquisition and productions costs of the property (for buildings built post 1924 2 % can be depreciated annually for 50 years)
- Costs for renovation and repairs of rented units (20 % with a maximum of € 6,000)
- Interest on mortgage financing
- Property taxes
- Real estate agent’s fees
- Costs pertaining to lawyers and tax consultants
- Additional costs of tenants as advertising costs
- Other: Account fees, charges relating to office, travel, telephone of the rented property as well as advertisement charges
Homeowners and landlords should in any case get tax advice in order to fully benefit from state subsidies and tax concessions. The amount of the tax savings often depends on individual case decisions, especially in the case of properties used by third parties.
Increasing returns on real estate investments by using leverage
Increase/optimization of current rental return
Rental income largely determines the success or failure of a real estate investment. Landlords can thus evaluate it by using their regular rental income, but should deduct the loss of rent risk in the amount of the average vacancy rate in order to determine a realistic rental return. In addition, the amount of the potential rental income has a major impact on the valuation of the investment project. Satisfied tenants can prevent losses in rental income. The investor should pay attention to maintenance and renovations, quick elimination of deficiencies and control of operating costs. For larger or a multitude of residential properties, a professional facility management is worthwhile for landlords.
Increase in value and capital gains
Early maintenance measures help to preserve the substance of the building. Modernization, refurbishments and modifications increase the value of the property. Whether an increase in the value of the property actually occurs at the time of a possible sale depends on many factors in the real estate market. The lower the purchase price in a good location, the higher the chances that the value of the property increases over time. Regions with excessive price claims or without future prospects are to be avoided in the rental of residential or commercial properties.
Optimization of the financing structure
Increasing the equity return
By comparing the property return of different real estate objects one can find out which property is the most profitable. In addition, the property return indicator is suitable for assessing whether the leverage effect can be used sensibly, since it covers all revenues and expenditures as well as tax implications, but not the consequences of the financing structure
- The index for the property return is calculated according to the following formula: Rental income minus any maintenance costs minus the tax burden.
Due to a restriction of tax advantages for real estate in recent decades, the return has to be increased by other means. The interest of the used savings capital can be improved by the leverage effect of an increased use of external capital. The external capital needs to achieve a higher return than it costs; in times of low interest rates this is easily possible. For individuals, however, the repayment ability and the avoidance of a debt overload are the limit for an expansion of the loan. Repayments should not exceed the depreciation or a certain proportion of the net income.
Decreasing the capital costs
The criterion for an optimal financing structure is the comparison of as many financing offers as possible. A good credit rating of the borrower is also very beneficial. Measures to improve the credit rating, such as additional collateral, help reduce capital costs. Choosing a fixed-rate loan instead of an annuity loan can optimize the financing structure.
The interest can be deducted from the tax, so it makes sense to put the repayment premiums into a savings plan for the asset generation according to one’s own tolerance and ability to bear risk. The fixed loan will thus be completely replaced. The major advantage of this method is a constant monthly charge for the borrower during the entire financing period. The profitability of the use of proprietary capital can be increased when the equity goes into a premium’s account instead of the financing of the property and thus increases the interest charges and the tax advantages. The final loan is repaid with the credit balance of the premium’s account. However, in this case, the borrower should have a good credit standing.
With real estate investments, market-oriented returns are possible and investors should not rely on tax advantages only. First of all, the location of the property determines the amount of the landlord’s return. Real estate in sought-after urban locations in large cities are an advantage over small towns and peripheral areas. Tenants also look for housing in the city centre and economically prospering regions. The location of the property is also a decisive factor for achievable returns when the property is sold. In real estate trading, the location of the real estate property is therefore mentioned first. The condition of the building and the quality of the infrastructure also play an important role.
In the case of the return, prospective buyers should make sure that only realistic net return information is selected as a basis for comparison and that the purchase price is not too high in relation to other objects and investment classes. The buyer may not be able to change the rent level or legal regulations, however a buyer does have a choice in regards to the acceptance of a rental agreement or the purchase price. In addition to the location and supply and demand, it also depends on the investor's attitude and risk profile, as well as the level and composition of his assets. The profit does not only lie in the purchase of a property as with shares. The investor can avoid purchasing a property at a price too high by making use of market knowledge and good timing, without any time constraints and possibly with professional assistance from a broker. However, the risks of a real estate acquisition must not be ignored, especially since most [real estate investments] are associated with high investment sums and can quickly lead to a cluster risk in the asset composition of the investor. Diversification is easier with participation forms such as real estate crowdfunding, REITs or open-end real estate funds.