What's a good return on a real estate investment? The answer is in the eye of the investor.
Real estate investment has many variables. Returns vary by location and comparable properties, market conditions, and how you calculate total return on investment (ROI). For this reason, it's hard to know what an “average” return is.
However, since real estate is local and you have your choice of real estate asset classes, you should be able to roughly estimate a reasonable expectation of ROI.
How your real estate return is determined
Calculating ROI is complex because of several factors you could use to evaluate your real estate investment. Basically, your ROI in real estate comes from two sources:
- Regular income from rents or dividends.
- Appreciation from holding a piece of real estate or a real estate investment trust (REIT) stock over time.
Your goal should always be to hold property or REIT shares for at least five years. 10 or more is even better. This gives you a better chance of realizing returns from both income and appreciation.
Let’s say you buy a rental property for $100,000 in cash. Your annual net operating income (NOI) after expenses is $8,000. You hold the property for 10 years. For the sake of simplicity, let’s say your NOI stays the same that whole time and you sell the property for $200,000.
Not only have you made an 8% annual return on your property investment, but you’ve also made a $100,000 profit. That's a total of $180,000 in profit over 10 years. You’ve almost tripled your money. This is before real estate taxes, which are at ordinary income rates on rental income and long-term capital gains rates on the appreciation.
A good real estate return to shoot for
The definition of a good return on real estate varies by your risk tolerance. Many analysts and investors use average returns on the S&P 500 as their benchmark, meaning any investment that can beat it is a good use of their money. Over the past 50 years or so, the average rate of return for the S&P 500 has been about 8%.
Because the S&P 500 is made up of 500 large-cap domestic companies that comprise most of the country’s market capitalization, it’s representative of how the economy is doing and the market’s response to it.
Returns on tangible real estate
Tangible real estate offers returns that can beat the S&P 500 -- in part because of your ability to leverage it. In other words, you can take out a mortgage and increase your cash-on-cash return, leaving open the possibility of using your other funds to purchase more properties.
For example, if you bought that same $100,000 property mentioned above with a mortgage on which you put down $20,000 and still earned $8,000 in NOI, your cash-on-cash return is a whopping 40%. But your mortgage interest would be added to your cost basis, meaning your profit wouldn’t be quite as high when you went to sell as it would be if you had paid with cash.
A property’s capitalization rate, or cap rate, is another way to benchmark a particular neighborhood and/or asset class. The cap rate is calculated by dividing net operating income by the sale price, purchase price, or current market value of the property.
You can also use the NOI and cap rate to calculate a property's market value.
Say you want to make an offer on an income-producing apartment building with an NOI of $50,000 per year. You know from recent commercial appraisals and market research that the average capitalization rate of comparable sold properties in the neighborhood is 7%. That makes the market value of the building about $714,285 (divide $50,000 by .07 to arrive at this number).
If you paid for the building in cash, you would earn 7% on your money each year with income from rents. If you buy the property for $600,000, you’d get a steal -- that's a below-market price based on the building's NOI for the neighborhood.
The average cap rate for an apartment building in a neighborhood may be different than it is for an industrial or retail property. Each asset class may have a different standard for the area.
Returns on REITs
REIT let investors diversify their investment portfolios without running and managing a property themselves. REITs, which often own large developments and apartment complexes, must pay 90% of their income as dividends to shareholders. This raises the return over time -- even into the double digits. Private REITs can be risky and don’t have the same regulations as publicly-traded REITs, and investors should exercise caution when considering them.
REIT returns are more volatile than tangible real estate -- they go up and down over short periods -- because they're publicly traded. According to industry group NAREIT, though, the average compounded annual growth rate for REITs over the past 20 years is 9.9%.
Stick to your long-term goals
The best method for investing is to choose a strategy for achieving your long-term goals and stick with it through thick and thin.
Your returns in real estate will be determined by prudent buying, selling, and management decisions. And your ability to stick it out through various ups and downs is crucial, too.
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