How to calculate the profitability of a property

How do you know if your investment will be profitable? After all, this is the most important question before starting any actions with the real estate that you expect to rent.

Many future investors, due to lack of time or knowledge, rush into the business, like into a pool with their heads, with emotions and without any calculations, overly trusting the seller or real estate agent.

It is also important to be able to calculate profitability in advance because if you know what it consists of, you can influence it. This will also allow you not to buy into the promises of "golden mountains" from sellers or agents, but to calculate everything yourself, because after the documents are signed with a notary, it will be too late to win back something.

So learn how to perform rental roi calculations below.

1. The purchase price is the determining factor in future profitability.

This includes the cost of the property itself, as well as all costs associated with its acquisition:

- expenses for notarization;

- payments to the real estate agency;

- possible expenses for real estate renovation, etc.

1. Estimated rent.

This is the rent you can get for your property after renovation. And not the amount for which housing is rented now. The current rent is a good guideline in itself, though.

Renovation can be quite light, just to refresh the apartment, it can only concern the decor of the kitchen and bathroom. But it can also be significant changes - with redevelopment and even dividing one apartment into two.

Changes may also apply to the form of lease: with a long-term one, you can switch to daily.

But in some form, an indicative rent is absolutely necessary to calculate profitability.

Example of calculating profitability

How to calculate the cost of an apartment

We choose a city (I chose Reims) on some large site of private ads like bon coin, we are looking for an apartment of 30-50 sq. m.

I chose a two-room apartment of 32 sq. m, put up for sale for 55,000 euros. I don't need to know anything else yet.  

Purchase price:  55,000 euros, but the indicated value is unlikely to be the selling price, except for an apartment in the capital, but also not always. I will proceed from the principle that bargaining at 10% is possible, since this is a common practice. Then the final purchase price will be  49,500 euros.

Notary fees:  in France it is 3% of the transaction, that is, in my case,  3960 euros.

Real estate agency expenses,  if any: in France this is 6% of the transaction, that is,  2,970 euros.

Renovation: 10,000 euros. It is possible to estimate in the most general terms from the photo on the site how much the housing needs repair, but all this will then require a mandatory assessment on the spot. For this apartment, I see that it looks clean, but the bathroom is too old, and there is no photo of the kitchen at all.

Furniture:  I assume that I will rent out the apartment with furniture, we will calculate  3000 euros.

Total: 66,430 euros.

How to calculate the possible rent?

To answer this question, we return to the same site with ads, but in a different section, put ourselves in the place of a tenant and start searching. What can I find for myself if I am going to rent housing from 30 to 35 sq. m?

Of course, this is the most approximate calculation, where I cannot accurately calculate the rent in this particular place in the city. But I can focus on housing "in the city center", because "my apartment" is also in the center, as indicated in the advertisement for the sale.

It turns out on average 450-500 euros per month. The top bar is 605 euros, but this is quite in the historical center, with an excellent new renovation, with household appliances and furniture. I will assume that I will be able to rent an apartment for  550 euros,  as I am planning a good repair there and new furniture. 

Real estate tax concerns are driving rents up. Find out more at  https://www.nytimes.com/video/multimedia/100000003534332/property-tax-fears-fuel-uk-rental-rise.html?searchResultPosition=23

Benchmarks for assessing potential profitability can be found in just a few minutes. If in the future everything turns out to be good, then all the numbers will need to be carefully checked again. It is still necessary to find out if this deal makes sense at all.

Types of profitability

I must definitely remind you that there are three types of profitability: "dirty", "clean" and absolute profitability.

Profitability "dirty" does not include operating costs.

The "clean" profitability already takes into account the operating costs.

Absolute profitability  - profitability less operating costs, loan repayments and taxes. This is real profitability.

We must also take into account the “rental holidays”, which investors often forget about. This is the time that your apartment will be empty a year, the gap between two tenants. It happens that one tenant stays for 5-15 years, sometimes 1-3 years, you never know how lucky you are. Let's take 15 days a year for the calculation. It is especially important to consider such "rental holidays" for such small apartments as this 32 sq. M. m, because the tenant can be a student or a very young worker.

Annual rent adjusted for 15-day "rental holidays": 550 × 11.5 =  € 6325 .

We consider profitability as "dirty"

Please note: many, especially sellers, consider the profitability at this stage only on the basis of the cost of the apartment, misleading you. 

49,500 + 3960 + 2970 + 10,000 = 66,430 euros.

6325 × 100/66 430 =  9.5%.

Such profitability of the “dirty” ones is quite acceptable, it is close to the average values, although far from ideal. When we calculate from it the maintenance costs and taxes, things will not be so rosy.

How can profitability be improved at this stage?

It was necessary either to buy it cheaper, or then to rent it more expensive. This is how rent will affect your profitability.

But calculating the profitability of the "dirty" in general does not really mean anything. This is roughly like the number of visitors to the site per day or the turnover of an enterprise, the so-called vanity metrics, numbers that can flatter your vanity, and nothing more. To know the true state of affairs, you must deduct the mandatory operating costs. 

Operating costs

Take the exact figure, if there is anywhere to get it, or guess the likely amount. 

- Maintenance, which you will pay constantly. You can calculate the approximate annual repair as a percentage of 1 sq. m.

- Expenses for the maintenance of the building and the adjacent territory. Even before buying, you can make inquiries and find out exactly the amount. For now, I will spy them in the ad on the website:  679 euros.

- Expenses for the legal functioning of my "enterprise":

• management (the agency usually takes 6-10% of the rent);

• insurance (90 euros per year);

• accounting (300 euros per year);

• real estate tax (1-2 rent per year);

• unforeseen expenses for building maintenance (roof repair, replacement of heating pipes, replacement of a gas boiler, etc. These are rare, but have a significant cost);

• taxes. It happens that completely legal options are also possible in this column, check the legislation of your country.

Profitability "clean"

Final purchase price:  66,430 euros.

Building maintenance costs:  € 679 per year.

Operating costs:  € 1140 per year.

Renovation: 5% of the rent =  330 euros per year.

Total costs:  € 2,149 per year.

Annual rent including "vacation":  6325 euros.

Net income: 6325 - 2149 =  4176 euros per year.

Profitability "clean": 4176 × 100/66 430 =  6.2%.

As you can see, we lost 3% profitability when we took into account many factors that novice investors most often forget about.

But we still do not know how much the net income will be, how much money will remain after deducting all possible expenses, including payments to the bank on the loan.

Absolute profitability, or net income

Rent minus necessary operating costs:  4176 euros.

Loan payments: € 347.87 × 12 months =  € 4174.44.

To find out that last figure, I typed into a Google search box "calculating monthly payments on a real estate loan." In the line “loan amount” I have included the cost of the apartment € 66,430, the loan term is 20 years. And the calculator gave me  "347.87 euros including insurance". 

Of course, in practice, it will be possible to find the best interest, which will reduce the monthly loan payments.

Taxes must also be deducted from the balance! The amount of tax will depend on many factors, inquire according to the laws of your country. In France, for example, you can find loopholes to not pay this tax at all for 7-9 years legally.

That is, the net income from this apartment for me will be: 4176 - 4174.44 =  1.56 euros per year  , provided that I do not pay taxes.

All this work to get the bottom line of 1.56 euros per year!

This is why it is very important to calculate the real numbers, taking into account commonly overlooked factors. Our goal is to achieve the best result after all.

Perhaps, in this situation, I will not buy this apartment now. Although if my goal is to create a fortune for myself that will at least finance itself, such a purchase is better than none at all.

The purpose of this exercise is to show you how at first glance, "amazing ROI" can actually go to near zero. 

I must say that on the Internet there are many ready-made "calculators" for calculating profitability. But if you show in detail what it consists of, then you will understand what indicators you can influence in order to improve it.