Types of return on investment

 Types of return on investment


The main reason people invest in real estate is to make money. Return on investment is the metric that enables real estate investors to see the efficiency and profitability of their investment. This is why return on investment is vital to determining whether or not an investment opportunity is profitable and worthwhile. There are three main types of return on investment, which we will cover in this article.

The expected return on investment
The first type of return on investment is the amount of profit or loss that a real estate investor expects to achieve from an investment property that has many known or expected potential outcomes.
The expected return is calculated by multiplying each of these possible outcomes by their probability of occurring, then summing the results. The problem here is that we don’t actually know the probabilities of each outcome, so the best we can do is estimate the expected return, hence the name.
How to calculate expected return on investment
If a real estate investment has a 50/50 chance of making a 20% profit and a 10% loss, the expected return on investment is:
(50% x 20%) + (50% x -10%) = 5%
Not only is this type of ROI applied to individual investment properties, but it can also analyze an entire real estate portfolio containing many investments. To calculate the expected return of an investment portfolio, a real estate investor simply needs to add the weighted averages of the expected returns for each property. The expected return on investment equation for a portfolio of three investment properties is as follows:
Expected return = (value of property A) x (expected return of property A) + (value of property B) x (expected return of property B) + (value of property C) x (expected return of property C)
Once you know the expected return for each property and calculate its value, the investor simply multiplies the expected return for each property by its value and then adds up the values ​​obtained. Assume the following portfolio of investment properties:
Property A with an expected return of 15% and a value of 50%
Property B with an expected return of 6% and a value of 20%
Property C with an expected return of 9% and a value of 30%
The expected return for this investment portfolio is:
(50% x 15%) + (20% x 6%) + (30% x 9%) = 7.5% + 1.2% + 2.7% = 11.4%
Remember that because markets can be difficult to predict, calculating the expected return on an investment property is more of a guess than a certainty.
The required rate of return on investment
The second type of return on investment is the required rate of return, which is key for real estate investors to downgrade and evaluate investment properties before deciding whether or not they should go ahead with their purchase. It is simply the minimum necessary return required for an investor to consider a particular investment property.
The required rate of return on an investment affects the maximum price that real estate investors are willing to pay for an investment property given the risk-free rate of return and expected rate of return. If the expected rate of return does not meet or exceed the required rate of return on the investment, the investor may not be willing to take on the additional risk.
How to calculate the required return on investment
Here’s the formula:
Required rate of return = risk-free rate + risk factor (expected return – risk-free rate)
If a real estate investor is considering purchasing an investment property with an expected rate of return of 10%, suppose the risk-free rate is 3% and the risk factor is 0.75. Using the above formula, the required rate of return on this investment would be:
0.03 + 0.75 (0.1 – 0.03) = 0.05 = 5%
Is 5% a good ROI in relation to the maximum price you are willing to pay? The required rate of return for real estate investors varies depending on their risk tolerance, real estate investment goals, and other factors. Therefore, a high interest rate of 5% may be a risky investment for some real estate investors and hence, they may decide to go for a low-risk investment property. On the other hand, others may consider this an acceptable return and go ahead with the investment property purchase.
The actual return on investment
The third type of return on investment is the actual return, which refers to the actual amount of money earned or lost from an investment property over a period of time. In other words, it is what real estate investors actually get from their investment properties.
How do you calculate the actual return on investment?
The formula for calculating effective yield is very easy:
Actual yield = (ending value – starting value) / starting value
Suppose you plan to buy investment property at an initial price of $100,000 (initial value) and then, years later, sell the investment property at $120,000 (final value). In this scenario, the actual payout you received equals:
(120,000 -100,000 USD) / $100,000 = $20,000 / $100,000 = 0.2 = 20%
Do not confuse the actual return with the expected return, the expected return is the profit that the real estate investor expects to earn, while the actual return on investment is the profit that the real estate investor actually achieves after purchasing an investment property and then selling it later.
Ways to make money from investments
When choosing an investment, you should consider how you expect to make money from it, and how your profits will be taxed.
1- Interest
Investments such as savings accounts and bonds pay interest. With these types of return on investment, you know exactly how much money you will earn on your investment.
2- Dividends
Some stocks pay a dividend, giving investors a share of what the company makes. The amount of dividends depends on how well the company performed that year and the type of shares it owns.
3- Capital gains
As an investor, if you sell an investment such as a stock, bond, or mutual fund, for more than you paid for it, you will suffer a capital loss.
Types of return on investment are an important concept in real estate. Investors should be aware of how these types of return on investment are calculated to ensure that they are making the best investment decision before purchasing an investment property.

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