There are a number of real estate words and terms you will want to understand as you progress through your real estate journey. You can maximize your ROI by leveraging capital to purchase an expensive property with little money down and forcing equity to appreciate your asset. What does that mean?
The Concept of Return on Investment (ROI):
ROI measures the profitability of an investment. It’s calculated by dividing the net profit from the investment by the initial cost and is usually expressed as a percentage over a single year. A high ROI indicates a profitable investment.
An example ROI is if an investor puts $100,000 into the purchase and renovation costs of their property, then turns around and sells it after 1 year for $120,000. It is a 20% ROI. For comparison, the stock market yields an average return of 5-7%. Well-planned flips typically yield a much higher ROI than you’d get from traditional investments since flipping involves taking on risk and putting labor and effort into the project.
Generating Cash Flow:
Cash flow is the net amount of cash being transferred into and out of a business. In real estate, it’s the income generated from rental properties after deducting expenses like mortgage payments, property management fees, maintenance costs, and taxes. This is most important for investors who wish to hold onto their properties and rent them out in lieu of “flipping”.
For example, if a property is being rented out for $1,000 a month, the mortgage is $500, the property manager takes 10% and $100 is spent on cleaning the HVAC the net cash flow for the property is
1,000 (income) - 500 (mortgage) - 100 (property manager) - 100 (maintenance) = $300
That is $300 that goes straight into the investor’s pocket.
Leveraging Borrowed Capital:
Leverage involves using borrowed capital (such as a mortgage) to increase the potential return on investment. By putting down a smaller amount of money and borrowing the rest, investors can control a larger asset and amplify their returns.
While some “financial experts” will steer folks away from “getting in debt” this is not always savvy advice. If a borrower has the cash flow to support the monthly mortgage payments this is an extremely effective way to help scale a portfolio. It is essentially utilizing the bank’s resources to build wealth for yourself. That being said, it is never smart to be irresponsible and put yourself in a position where you can’t make the payment or the bank calls the note due and you have to sell the property at a loss.
Appreciation in Real Estate:
Appreciation refers to the increase in property value over time. Factors influencing appreciation include location, market demand, economic conditions, and improvements made to the property.
The average home appreciates at around 3% per year. So a $100,000 would be worth $103,000 after year one. While 3% feels low compared to some other investment methods it is important to remember that if a property is purchased for $100,000, typically the investor is only putting down around 20%. That means a $20,000 investment has a $3,000 return which is a 15% realized gain for the investor’s net worth.
Home Equity:
Equity is the difference between the market value of a property and the amount owed on the mortgage. As the mortgage is paid down and the property value appreciates, equity in the property increases. When a property is sold, after commissions and closing costs, the “equity” is the amount of cash taken home.
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