Is a 20% Annual Return in Real Estate Good for Investment Properties?
When someone suggests a 20% annual return in real estate seems too good to be true, they might be right or they might be bragging. A 20% return can be considered good, bad, or somewhere in between, depending on the type of investment and the metrics you're measuring.
Factors Influencing a 20% Return in Real Estate
The magic of a 20% annual return in real estate depends primarily on the type of investment property and how you measure success. Here are some examples to illustrate this point:
Buy-and-Hold Investment Property
Example 1:
You buy an investment property for $100,000 with a 20% down payment, or $20,000. The next year, the property is worth $104,000. To calculate the return on investment (ROI), the formula is:
ROI (Final Value - Initial Investment) / Initial Investment
In this case:
ROI ($104,000 - $100,000) / $20,000 0.02 or 20%
While a 20% ROI is a solid return, it might not be enough to cover the operational and maintenance costs associated with the property. In other words, your initial investment might not be generating sufficient passive income to outweigh the repairs or replacement costs, which is why a 20% return alone may not be desirable.
Example 2:
Same scenario: You buy an investment property for $100,000 with a 20% down payment, or $20,000. The next year, the property is worth $120,000. Using the same ROI formula:
ROI ($120,000 - $100,000) / $100,000 0.20 or 20%
This time, the property's value has increased significantly, from $104,000 to $120,000. However, it is crucial to consider the net cash flow you are generating. If the gross income from rent is just covering the mortgage and not generating net profit, you may be at a loss despite the 20% value gain.
Example 3:
Same scenario: You buy a property for $100,000 with a 20% down payment, or $20,000. The property's value remains the same at $100,000. However, in the same year, you receive $4,000 in net cash flow. Using the ROI formula:
ROI $4,000 / $20,000 0.20 or 20%
This scenario shows that a 20% return is acceptable as long as it is used to cover the costs of necessary repairs and maintenance. For example, a new roof costing $12,000 might eat up 6 years of positive cash flow, making the overall return less favorable.
Example 4:
Same scenario: You buy a property for $100,000 with a 20% down payment, or $20,000. The next year, the property is worth $120,000. However, the rent doesn't quite cover the mortgage, and you have to spend $6,000 on a new roof and $3,500 on a new HVAC unit. Additionally, you spend $600 on a hot water heater and $800 on a new washer and dryer. You may have gained $20,000 in value, but you could be $8,000 to $10,000 poorer in the aftermath.
Rehabbing
In the scenario of rehabbing:
Example 5:
You buy a property for $100,000 and put $20,000 into the renovations. You sell it for $140,000, making a $20,000 profit or 20% ROI. This is a modest return but not particularly impressive. Using the formula:
Magnitude of appraisal (MAO) After repair value (ARV) x (1 - repair costs / ARV)
To achieve a 20% ROI for the rehabber, the after-repair value (ARV) would have to be such that the purchase price (MAO) is around $78,000, considering typical expenses.
An even better scenario: If you do two rehabs in a year and make a 20% profit on each, contributing to an overall 40% return. Such a level of performance is more impressive and indicates superior market knowledge and execution.
Wholesaling
Wholesaling involves putting a property under contract and assigning the contract to a rehabber. If you do a wholesale deal for $100, with a 20% return, it would mean assigning the contract for $120. This is generally considered terrible. However, a typical wholesale fee might range between $5,000 and $20,000, providing a 5000 return on $100, which is still a good investment. If you replicate this deal four times a year, you would make $20,000 without spending any additional transaction fees. While there are marketing expenses, this example demonstrates that a 20% return can be achieved without significant outlay.
Conclusion
A 20% annual return in real estate investments can be good or bad, depending on the investment type and the factors you are considering. While a 20% return is attainable, it is generally advisable to aim for a higher return for long-term investment sustainability. Always factor in operational costs, maintenance, and potential ups and downs in the market to ensure that your return is both economically feasible and financially rewarding.