The Return on Investment often referred to as its ROI, is a very useful measure for investors to make truly informed decisions. However, ROI is just one measure of the financial performance of an investment and successful investors need a full range of measures in order to determine what is the right investment for them.
Successful investment decisions can only be made by:
- Understanding how to measure financial performance.
- Being able to use this analysis to compare different investments.
Many people find measuring financial performance a complicated and overwhelming process. However, it does not need to be. Understanding how to map financial performance puts you in a powerful position because it gives you the confidence to make decisions based on facts and logic. Learning these skills can be difficult; however, doing so will improve your effectiveness in making investment decisions.
Other than a loss, investment property is only capable of generating two financial outcomes:
- Capital appreciation: The difference in the value of your property at a given point in time less your costs to purchase the property; and
- Income: Rent paid by tenants
How much of each you are looking to generate will change over time as your investment objectives change.
You need to be able to calculate how much of the financial returns you get to keep, versus how much is absorbed by taxes and other costs.
Six key financial metrics you need to generate, to determine which property best meets your investment objectives:
- Cash required: How much cash is required to purchase the investment?
- Net cash flow: How much cash will an investment generate after covering costs?
- Net income after tax: How much income is left after paying tax?
- Capital appreciation: How much capital appreciation will the investment generate?
- Available equity: How much available equity is your property generating which you can reinvest in other properties to grow your portfolio?
- Net return on cash if sold: How much net income does the investment return, relative to the cash required?
Calculating the ROI
The ROI is a performance measure that compares the efficiency of a number of different investments. ROI measures the amount of return on a particular investment, relative to the investment’s cost.
To calculate the ROI, the net return of an investment is divided by the cost of the investment. The result is expressed as a percentage (or a ratio).
Let’s compare the potential return for an investor purchasing a property for £400,000 with and without a mortgage.
Let’s assume both investments grow by 5% p.a. After 5 years, the two alternatives will be as follows.
|Scenario 1 – with a mortgage||Scenario 2 – no mortgage|
|Growth rate||5% p.a.||5% p.a.|
|Value after 5 years||486,203||486,203|
|Capital Appreciation on the initial investment||86,203||86,203|
|Return on Investment||86%||21%|
In the above scenario, the ROI is calculated by dividing the capital appreciation 86,203 by the initial cash put in (so, 100,000 for the buyer with a mortgage and 400,000 for the buyer not using a mortgage.
The ROI is far greater in the scenario when the investor uses a mortgage, because their initial cash investment is only 25% of the purchase price, whereas when the investor doesn’t use a mortgage, the initial investment is 100% of the purchase price.
Investors can compare the ROI for different variables, such as comparing a one-bedroom property with a two or three-bedroom apartment, or for comparing the ROI based on different potential growth rates.
Du Val Global
The viability of property investment cannot be measured on ROI alone. The viability needs to be assessed using a number of measures and on an after-tax basis. But it’s difficult and time-consuming to build financial models to help you analyse the performance of one property, let alone compare different investments.
Du Val Global has built sophisticated but intuitive calculators that help you forecast the net return after tax, equity position, and return on cash, regardless of where you live, or where the property is located.
The Portfolio tools help you to assess if a new property will be additive or dilutive to an existing portfolio.
You’ll be able to sign up for a free trial and access these exciting new tools soon.
Important notice: Proptech Pioneer and its associated companies seek to provide real estate investors with guides, information and tools, but we cannot guarantee this information to be accurate or perfect. You use the information at your own risk and accept no liability if you rely on this information. Proptech Pioneer is not a tax advisor, accountant conveyancer, lawyer, financial advisor or mortgage advisor. You should seek independent advice from independent professionals before making any investment decision.