How Important is Price when it comes to ROI?

How Important is Price When it Comes to ROI?

One of the most commonly used valuation models for single family homes and short sales includes the Return on Investment or ROI. Despite the ease associated with using this calculation, the ROI is a robust measure of investment value that is both quick and convenient. However, it is also subject to a high level of volatility based upon the price of the property and type of funding in place. In fact, ROI is so dramatically influenced by funding mechanisms that it is frequently considered a cornerstone by investment advisers.

How to Determine ROI

Have you ever heard the saying..."You make your money on the way in."?

“How important is price when it comes to ROI? The final answer is “it depends.” Certainly buying right is a critical consideration in any real estate deal. However, when using leverage, price becomes much less important due to the extreme rates of return generated.

Real Estate investors should fully understand how to maximize ROI depending upon the price and funding source to be utilized for the deal. By doing so it is often feasible to pay more for a property while still maximizing the full profit potential of your portfolio.”

Cash is still king and it speaks louder than ever especially with tightening lending standards and other banking irregularities; however, one area where cash doesn’t hold up quite as well as the use of leverage is in the calculation of ROI or return on investment. Let’s assume an investor opts to purchase a property in cash for $100,000.

If the property generated a one year rental return of $10,000 the total ROI is a fairly straightforward 10% or perhaps the property was flipped for a $20,000 profit and thereby the ROI was a handsome 20%. Both are completely realistic examples and certainly above and beyond what stocks, bonds or other inferior investments are currently able to deliver but the total return is a bit misleading. This can be due to the cost of borrowing the money. What interest rate is being paid on the funds borrowed? If the buyer took out a home equity loan, the interest rate might be 4 percent leading to a ROI of 6-7 percent.

On the other hand, some properties are truly purchased completely for cash so the entire ROI is a simple mathematical procedure. Is buying for case the best situation? There are a multitude of reasons to purchase a property for cash; 1) You cannot obtain full financing on the property 2) the ease and convenience of closing and 3)the cost savings of not having to obtain PMI.

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However, there are very strong reasons to finance a property or use the maximum amount of leverage possible to maximize ROI. Going back to the former example, let’s assume you financed a property for 80% of the value. That is you borrowed $80,000 of the total price of $100,000. You used $20,000 out of pocket and received the same $10,000 annual rental or flipped for a quick $20,000. Instead of a respectable 10% to 20% return, you will now realize an eye-popping 50% to 100% return on your investment!

Return on Investment (ROI) Basics

Now let’s take this one step farther…how important is price when it comes to how much money can you put in your pocket? Certainly buying right is a critical consideration in any deal however, when using leverage, price becomes much less important due to the extreme rates of return generated. In the above examples, every $1,000 addition in cost reflects a significant gain or loss in the final cash ROI but in the leveraged position, paying an additional $1,000 for a property results in a small difference in the final ROI. Investors should fully understand how to maximize ROI depending upon the price and funding source to be utilized for the deal. By doing so it becomes very clear which plan you should use to maximize the full profit potential of your investment