Once upon a time there was a gingerbread house. It was lovely decorated with lots and lots of candy…
How often we have heard it. “If something looks too good to be true, it probably is”. Unfortunately, a real estate investment is no fairy tale with a happy ever after. Especially when it comes to profit, we must be careful with promises of an unrealistic high rate of return.
But to know if something looks too good to be true, we first need to know what is a realistic rate of return for a real estate investment? And how is it calculated?
The rate of return shows how much profit in percent is made per year in relation to the money spend. Like this it is possible to compare one real estate investment to another or even compare it to other types of investments.
When a percentage value is mentioned as a return on real estate, a serious investor should first ask what return is meant. A distinction is made between gross and net return (or some also call it “cap rate” meaning Capitalization rate).
The gross return covers purchase costs and additional purchase costs, but not ongoing expenses such as administration and maintenance costs or taxes.
It is calculated like this
annual income divided by purchase price x 100 = gross return in %
The net Return includes the current expenses except taxes, so the net return is always lower than the gross return.
It is calculated like this
annual income minus all expenses divided by purchase price x 100 = Net return in %
These are just the very basic types of return – of course there are others, more complex (price return, money-weighted return, time-weighted return…).
Let´s see an example.
You bought a house for 150,000 EUR and you rent it out for 700 EUR a month. Your expenses for the house are 2,000 EUR per year.
This means that your gross return is 5,6 %.
(700 EUR x 12 month) / 150,000 EUR x 100 = 5,6 %
Your net return on the other hand is only 4,26 %.
[(700 EUR x 12 month) – 2,000 EUR] / 150,000 EUR x 100 = 4,26 %
As a result, to get a good idea of your profit it is always better to look at the net return.
What is an average rate of return?
Depending on your country and the type of real estate (residential or commercial) your average rate of return would probably be something between 4% and 10%. Of course, the bigger the rate the better. But again, if the rate of return is very high in a real estate investment you must be cautious. Also look out for the wording “possible” or “potential” yield of …. Meaning you will need to do something to achieve that – maybe even investing more money.
So, if the rate of return in a real estate investment looks too good to be true maybe take a closer look at the tenant of this nice “gingerbread house” or bite marks on the walls….