ROI stands for “return on investment,” and it’s a key concept for any investor to understand. ROI answers the question “how much will I get back per dollar I invest?” It’s usually expressed as a percentage.
Example: You own a house. You assess the market value at $100,000, as is. You spend $5,000 in repairs and upgrades, but you are able to sell the house for $107,500. Your repairs added $7,500 in value for an investment of $5,000. Your profit was $2,500. Every dollar you put in on that project generated 50 cents in profit, after you recovered your investment. Your ROI on the project was 150 percent. Subtract 100 percent to account for what you put into it, and you realized a return of 50 percent on your $5,000 investment. Not bad at all.
Here it is in table form:
Assessed Market Value of Home: $100,000
Cost of repairs: $5,000
Home sale price: $107,500
Profit: $2,500
ROI (Profit/cost of repair) 50 percent (on cost of repair)
But as a property flipper, you need to pull back the lens a bit, and look at the bigger picture.
Consider: If you had just bought the house for $100,000 cash, and invested another $5,000 in repairs, your total investment (and, for tax purposes, your “tax basis” in the property – more on this concept in a future column) is $105,000. If your repairs added $7,500 in value, then you have an ROI of ($2,500/$105,000), or 2.38 percent.
Well, that’s not great, unless you can turn the property around pretty quickly and do the same thing several times per year. If you can make 2 percent on a transaction 6 times per year, all using the same $100,000 of investment capital, over and over again, you’re making 12 percent per year (disregarding compounding and taxes).
Well, that’s a nice, tidy return on total capital invested: You can’t get that much buying high-grade bonds at today’s interest rates. But gosh … you’d have to scout out, purchase, upgrade and sell a property every two months to pull that off! You’re working awfully hard for that 12 percent per year! If you divided your profits for the year by the number of hours you would have to put in to flip every 60 days, on average, you might not be making very much money.
Leverage
Let’s look at the problem at another level: using leverage. Leverage is simply this: using borrowed money to make your investments.
Let’s use the same house. It still had a sticker price of $100,000 when you bought it. You put up $20,000 of your own money, and finance the rest – a 4 to 1 leverage ratio. You invest $5,000, and sell the property for $107,500. You still profit $2,500 on the deal.* But your return on invested capital is quite a bit different. You, as the investor, didn’t realize an ROI of 2.38 percent. You realized a return on invested capital of ($20,000 + a $5,000 repair)/ $2,500, or 10 percent.
In table form:
House Price: $100,000
Down payment: $20,000
Financed: $80,000
Leverage: 4 to 1
Loan to value ratio: 80 Percent
Cost of Repair: $5,000
Profit: $2,500
ROI (on total capital) 2.38 percent
ROI (on invested capital of $25,000): 10 percent
Now, that’s a very good return for a year, for a stock or bond market investor. But you get to do this as many times as you can flip the house!
If you can flip every three months, you’re making 40 percent per year on your money – discounting compounding and transaction costs.
Not even Warren Buffett, one of the greatest investors in history, can boast those kinds of returns over time.
Leverage is the key to successful real estate investing. Overall, home prices have historically risen, on average, between 4 and 6 percent per year over the past 50 years. That’s not spectacular. And one recent study pegs the long-term return on house prices from 1975 to 2009 as actually negative. But the judicious use of leverage magnifies modest profits, allowing investors to generate many times the nominal, unleveraged profit.
But leverage can work against you, too: If you put down $20,000 on a $100,000 home, borrowing the rest, and it turns out to be a dog with fleas, and you can only sell it for $80,000 instead of the $100,000 plus transaction costs and costs-of-carry you are banking on, then you just got wiped out. You still have to pay back the full $80,000 loan. (In these cases, it’s often better to punt: Rent the property – hopefully at a profit on a cash-flow basis, and play for time.)
So while leverage increases potential returns, it also increases your potential risk, as well.
Go into every flip with your eyes wide open, and take nothing for granted. Confusion favors the bold in war; property flipping favors the thorough.
*Note: I am ignoring a number of things for the purposes of the illustration. In the real world, you also need to account for origination fees, estimates and appraisals, insurance, interest – or the cost of carrying the mortgage until you sell the house and pay off the loan, attorneys’ fees, property taxes, and the like. The takeaway, for those who are smart enough read footnotes, is that you cannot cut things this close!
Jason Van Steenwyk is a veteran financial industry journalist who has been fighting to make the world safe for the retail investor since 1999. He lives at Ground Zero of the real estate bubble in Fort Lauderdale, Florida.