What is ROI and How to Calculate it in Real Estate?

Every life decision that we make brings with it a set of consequences. Right from childhood, we are taught that when we choose the action, we choose the consequence. This becomes all the more salient when it comes to finances and investment. Our investments must bring us returns or add to our wealth to be profitable endeavours. So, we calculate the ROI or Return on Investment when we make any financial investments. Calculating returns on the money we invest in equity, bonds, bank fixed deposits etc., may be fairly simple, but in the case of real estate, there are a number of factors to consider. Let’s take a look at these. 

What is ROI?

Return on Investment or ROI is, simply put, the net profit or loss we make from any investment. It is a ratio of the profit or loss to the cost of investing. ROI is typically expressed as a percentage of the investment value. To understand this better, let us take an example – If you have invested INR X in a financial product. The bank or financial company may charge you an additional amount of 1% as their charges. Now when you get back the principal with the profit, there may be a tax levied on your earnings. Now to calculate your ROI on this investment, you must first ascertain the total cost of investment. In this case, it is X+(1% of X). Your net profit on investment is the amount you have received (Total return - Investment Amount) - Tax. So, your ROI calculator formula will look something like this -

ROI = (Net profit from investment ÷ Total cost of investment) x 100

ROI on Real Estate

If we take a look at the formulae above, we can see that calculating the ROI on real estate may be more complex than on other investments. This is because it is more difficult to calculate the total cost of investment, and the net profit is also influenced by a number of factors.

In the case of a residential property, your investment cost may include the price of the property, the registration and stamp duty charges, GST (if applicable), cost of interiors/repairs/renovation etc. Over time the property tax you pay or maintenance charges may also be added to the total cost of investment. Similarly, the net profit can be calculated only after the deduction of the TDS and capital gains tax burden that you may incur. While calculating the return on property investment may be complex, it is definitely not difficult, particularly if you maintain meticulous records of your expenses towards buying and maintaining the property.

Tax Considerations on ROI Calculation

The sale of a real estate property can attract a number of taxes, such as TDS and capital gains tax. Capital gains tax, in turn, can be short-term or long-term. Both can attract different slabs of taxation. Furthermore, there are provisions in the income tax act that can help you offset the burden on the long-term capital gains (LTCG) on the sale of property by reinvesting these in real estate or specific bonds. Indexation benefits can also be availed on capital gains calculation from the sale of the property. All these should factor into your ROI calculation. It may be a good idea to consult a tax expert or financial advisor to understand these tax implications.

Cash-on-Cash Return 

Unlike other financial investments, real estate is often bought and held for longer durations, even decades. This poses a challenge when we try to calculate the return on property investment. Real estate investors and property owners often use the cash-on-cash return to simplify their cash flow calculations. It is a measure of the annual return earned by a real estate investor or property owner vis-a-vis the expenditure made towards mortgage, maintenance, and tax on the property for the same year. In addition, the yearly return earned can be calculated by any rental income earned by renting or leasing the property.

Real Rate of Return

Another method of understanding the return on real estate is the real rate of return. Indians very commonly use this calculation for their real estate investments. The rate of return on any property that has been leased or rented can be calculated as follows –

{(Total annual rental income - Property Tax) ÷ Total cost of property} *100

Deducting the income tax on rental income (after standard deduction) from this rate of return yields the real rate of return on your property investment.

Conclusion

Several factors influence ROI in real estate. Researching and making an informed choice can help optimise some of these, like location, builder reputation, amenities and facilities, locality infrastructure, and quality of construction. Others, such as demand and market factors, may not entirely be in the homeowner's or seller's control.