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Return on investment (ROI) is a standardized metric to compare different investment opportunities, regardless of their dollar value.
For real estate investors, there are two main methods for calculating ROI: the cost method and the out-of-pocket method. Each approach assesses how profitable a property investment might be, taking into account financing, renovation costs, and market appreciation.
These calculations become especially important when your real estate investment options expand beyond traditional rental properties to include real estate investment trusts (REITs), commercial properties, and land development, where you need comparable metrics to see where your funds can gain the most.
Key Takeaways
- Return on investment (ROI) measures the profitability of a real estate investment by comparing total profit to total investment costs.
- The cost method calculates ROI by dividing investment gain by total initial costs, including purchase price and any improvements.
- The out-of-pocket method calculates ROI by dividing your current equity by the property’s market value.
- The out-of-pocket method typically shows higher returns than the cost method.
- Many real estate investors aim for ROI that matches or exceeds the S&P 500’s historical average annual return of about 10%.
2 Ways to Calculate Your Return on Investment (ROI)
The basic formula for calculating ROI in real estate is as follows:
ROI = (Investment Gain – Investment Cost)/Investment Cost
This formula can be applied using two different methods: the cost method and the out-of-pocket method. Here’s how each works:
The Cost Method
The cost method calculates ROI by considering the total cost of the investment, including purchase price and any improvements.
For example, let’s suppose your real estate investment involves the following:
- You buy a property for $100,000.
- You spend $50,000 on improvements.
- You then sell the property for $200,000.
Your ROI would be as follows:
($200,000 – $150,000) / $150,000 = 33%
Fast Fact
In 2024, the typical home seller was 63 years of age, had a median household income of $112,500, and lived in their home for 10 years.
The Out-of-Pocket Method
The out-of-pocket method calculates ROI based on the money you’ve invested rather than the total property cost. This method typically shows higher returns because it factors in the benefits of using borrowed money (leverage).
Important
The out-of-pocket method should only be used when borrowing (via a mortgage or other forms of leverage).
Using the same example but with financing, you would have as follows:
- Purchase price: $100,000
- Down payment: $20,000
- Improvements: $50,000
- Total out-of-pocket cost: $70,000
- Sale price: $200,000
Your ROI would be:
($200,000 – $150,000) / $70,000 = 71%
Factors That Affect ROI
The return on investment you receive can depend on a considerable number of factors, so it’s important to consider each one before investing.
Market Factors
Economic Conditions
Local job growth, population trends, and business development affect demand and property values. For example, no matter what kind of property you had, how well you did renovations, you were unlikely to get your fantasy sale price in 2022 or 2023, as the housing market sputtered under post-pandemic conditions and relatively high interest rates.
Housing Supply
The balance between housing supply and demand in your area influences both appreciation potential and rental rates. If there’s been a recent glut of housing, it’s a buyers’ market. If the supply is relatively low, you’re more likely in a sellers’ market.
Location
Beyond just the region where you buy, the specific location of a property within a metropolitan area or even a town also impacts ROI.
Properties in more desirable locations demand higher prices. If you buy a home in a good school district or near amenities like public transit, it should appreciate more quickly than a home in a weaker district or with fewer amenities nearby.
Regional Market Conditions
Where you buy a property is one of the most significant factors influencing your expected ROI—hence the old mantra that “the three most important things in real estate are location, location, location.”
Buying in a popular area where demand is high and growing gives you a better chance than buying property in a location that people are moving away from. However, that comes with a steeper cost, which affects your potential ROI.
Property Factors
Property Condition
The initial condition affects both renovation costs and potential appreciation. While distressed properties offer higher potential ROI, they require more expertise and carry more risk.
The more you spend on rehabbing a property, the more price appreciation you need to see to cover those costs before you can turn a profit. However, distressed homes are often much less expensive than similar nearby properties. That can give you more of a chance to earn a higher ROI.
Property Value Range
While higher-value properties may command higher rents, the relationship isn’t always proportional. A $500,000 property might not rent for twice as much as a $250,000 property.
Property Type
Different property types—single-family homes, multifamily units, commercial spaces, etc.—have distinct ROI patterns and risks. Let’s go through these in more detail now.
Real Estate Investment Categories
There are a few different types of real estate, each with different characteristics for investors to consider.
Land
Land is, quite simply, a plot of land with no developments on it.
Undeveloped lots are typically much less expensive than developed properties. However, you’ll need to spend a large amount of money improving and building on the land to generate a strong return.
Residential
Residential real estate remains investors’ most common entry point, encompassing single-family homes, condos, and small multi-family properties. These properties typically operate on one-year leases and are generally easier to manage than commercial properties. Key considerations:
- Average lease term: 12 months
- Typical down payment: 20% to 25% for investment properties.
- Typical maintenance costs: 1% to 4% of property value annually.
- The average American home in the mid-2020s, despite the problems of the early 2020s, had a 10-year ROI of over 40%.
Commercial
Commercial real estate, which includes retail spaces, offices and restaurants, typically requires more specialized knowledge and a higher initial investment. However, these properties are generally more stable for long-term returns because of their longer lease terms and since tenants typically agree to pay for much of the maintenance.
Commercial properties require the following:
- Longer lease commitments (typically five to 10 years)
- Higher initial investment capital
- More specialized property management expertise
- Commercial real estate was hit hardest by the combination of the pandemic, the increase in remote working, and post-pandemic interest rate spikes. In 2024, for example, ROI was negative from the year before (about 9%). The long-term picture was far rosier: it had about a 67% ROI over 10 years as of late 2024, with the 20-year ROI at about 350%.
Fast Fact
In 2024, industrial properties were the only sector among commercial properties to return a positive ROI. The average real estate space lost 6.7% while the value of office property lost 8% year over year as of October 2024.
Industrial
Industrial properties represent some of the largest investments in real estate, including warehouses, manufacturing facilities, and distribution centers. While these properties require substantial capital and deep market knowledge, they can provide steady long-term returns, especially with the growth of e-commerce. They have the following to consider:
- Higher initial investment requirements
- Strong correlation with economic cycles
- Current demand driven by ecommerce growth
- Average one-year ROI of 9.5% in 2024.
Fast Fact
The industrial investment property market has the largest value among these investments, with about $300 billion in value representing over a third of investment property.
Land
Land investment offers the lowest initial cost but requires significant expertise and development capital to generate returns. Undeveloped land can provide flexibility about potential use but typically requires the longest time horizon to generate returns. Investors should understand the following:
- Development costs and timelines
- Local zoning regulations
- Infrastructure requirements
Tip
Each property type responds differently to economic cycles, which means diversification is particularly worthwhile when investing in real estate.
What Is a Good Return on Investment for Real Estate Investors?
What one investor considers a “good” ROI may be unacceptable to another. A good ROI on real estate varies by risk tolerance—the more risk you’re willing to take, the higher ROI you might expect. Conversely, risk-averse investors may happily settle for lower ROIs in exchange for more certainty.
In general, however, to make real estate investing worthwhile, many investors might look for returns in light of those they can get for the S&P 500. Historically, the average annual return on the S&P 500 is about 10%, though that flattens out year-to-year volatility, which can be substantial. While real estate prices have certainly undergone some major shifts in the last decade, it’s still the case that property investment returns might at times be more modest, but they’re more stable historically.
An Alternative: REITs
Of course, you don’t have to buy physical property to invest in real estate. Real estate investment trusts (REITs) trade like stocks on regulated exchanges, and they can provide diversification without the need to own and manage any property.
In general, REIT returns are more volatile than physical property (they trade on an exchange, after all). Equity REITs delivered five and 10-year compound annual returns of 3.45% and 6.59%, respectively, in 2024, as measured by the FTSE Nareit All Equity REITs index. Updated statistics comparing REITs to the S&P 500 are below:
Costs That Can Reduce Your Return on Investment
To realize your ROI in actual cash profits, you have to sell the property. Often, a property will not sell at its market value, reducing your expected ROI if that was the number you based your calculations on.
In addition, there are costs associated with selling real estate, such as repairs, painting, and landscaping. The cost of advertising the property should also be added in, along with appraisal costs and the commission to any real estate agent or broker that’s involved. And, if there’s a mortgage on the property, it must be paid off.
Explain Like I’m Five
Return on investment is a measure of how profitable an investment is, expressed as a percentage of costs. Investors use ROI to compare the profitability of different properties: A profit of $1 million might not be so attractive, if the investment required is $20 million.
There are two methods for calculating ROI. The cost method calculates the gain as a percentage of the property’s purchase price, plus the cost of any improvements. The out-of-pocket method calculates the cost by dividing current equity by the market value. Although neither method is more correct, the out-of-pocket method tends to show higher returns than the cost method.
How Is Investment Real Estate Taxed When You Sell the Property?
When you sell investment property, any profit you make over your adjusted cost basis is considered a capital gain for tax purposes. If you hold the property for a year or more, it will be taxed at capital gains rates. If you hold it for less than a year, it will be taxed as ordinary income, which will generally mean a higher tax rate, depending on how much other income you have.
When Are Real Estate Sales Subject to Capital Gains Tax?
When you sell a real estate investment property, the IRS considers any profit a capital gain. If you owned the property for more than a year, you’ll pay long-term capital gains rates (0%, 15%, or 20%, depending on your income). For properties held less than a year, the profit is taxed as ordinary income.
However, investors can defer capital gains taxes through a 1031 exchange by reinvesting the proceeds into another investment property. You may also be able to deduct losses from property sales against your other income, subject to certain limitations.
How Is Income From a Real Estate Investment Trust (REIT) Taxed?
Real estate investment trusts, or REITs, can pay income to their investors in three forms: dividends, which are taxable at the same rate as ordinary income; capital gains distributions, which are taxed at the usually lower rate for capital gains; and returns of capital, which are not taxable.
How Is Rental Income Taxed?
If you have rental income from a property you own, you have to report that income when you file your taxes for the year, generally on IRS Schedule E. You can also subtract your related expenses to arrive at your total income or loss on that property for the year. Losses are deductible up to certain limits.
How Is Climate Change Affecting the ROI on Real Estate?
Property insurance significantly impacts ROI by protecting against potential losses and often adding to operating costs. But it’s a major discussion in the real estate community in the mid-2020s for another reason: Insurance premiums used to range from 0.5% to 1% of the property’s value annually.
However, given the impacts of climate change, from the wildfires in California to the hurricanes devastating communities all along the Eastern Seaboard, the U.S. has seen significant spikes in property insurance, with your expected cost now about 3% of the property value—and far more in some locations. In addition, insurance costs are expected to rise about 2% to 3% a year in the coming decade.
The Bottom Line
Understanding how to calculate your ROI on real estate investments can help you make decisions about property purchases, improvements, and sales. While the cost method offers a straightforward way to measure returns based on total investment, the out-of-pocket method shows how leveraging borrowed money can increase returns. That said, ROI calculations are just one tool in evaluating potential investments. Location, property condition, market trends, and your investment timeline all play crucial roles in how successful you will be.
Thus, while ROI calculation methods have their place, neither method tells the complete story of an investment’s potential. Consulting with tax and real estate professionals can help you understand which metrics matter most for your specific situation, especially when dealing with complex factors like depreciation, mortgage interest, insurance, and the potential tax implications of an investment.
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