ROI – Part Two

A few weeks ago, I wrote an article talking about Return on Investment or ROI and talked about how it applies to Real Estate investments. Now ROI can actually be quite a complex subject and there are a significant number of variables that can affect the actual formula and ultimately the final return.
In my example, I really simplified this and one of the local readers, Mike R., sent me a great email calling me out on my simplification and providing some great comments for me. Mike pointed out that when you are making mortgage payments on your property, you are actually increasing your initial investment as you have to pay interest charges on the payments.
These interest charges actually increase the overall amount of money you have invested into the property which steadily decreases your overall ROI. Now, this is where understanding the difference between buying your home to live in and purchasing a rental property come into play.
In the case of a homeowner making his monthly mortgage payment, each month a portion of the payment goes towards the principal and a portion towards interest. These payments come directly out of his or her pocket and the interest portion directly affects the eventual return on their property. This cost of servicing the debt eats directly into the final return on their investment.
Over a 25 or 30 year mortgage this can amount to a significant amount of extra money going directly to cover interest only. Even with our current low interest rates it can easily double the initial investment or down payment you made if you put 25% down. If you were dealing with a 5 or 10% down mortgage, the amount becomes an even higher multiple.
On the other hand, when a Real Estate investor makes a mortgage payment, ideally, he isn’t taking any money out of his or her pocket after the initial purchase, but rather they are using the rental income to make the payments. This is an important distinction as this doesn’t affect the investor’s ROI, as the initial investment number never changes.
This also shouldn’t be confused with a situation where a homeowner has a second property they have decided to rent out while they wait for the market to recover. This has become a very common occurrence these days, but they are also typically horrible investments when it comes to ROI.
These types of properties often require capital to be fed into them as the rents typically do not cover the higher mortgage costs, or in the case of condos, the mortgage costs and condo fees. This puts you back into a situation of steadily diminishing your overall ROI.
A proper Real Estate investment should provide enough income to cover all the monthly costs, plus provide extra cash flow which can go towards reserve funds and profits in the investor’s pockets. Understanding this and then ensuring that the market in which the property is located has a good long term future for economic viability help ensure a great long term ROI.
I really do appreciate all the emails and comments I receive, so if you have any feedback or just want clarification on my articles feel free to email me or leave a comment on the Anchor.ca site.