How do you calculate ROI?

[Mike Rodriguez]

Hi All! I wanted to know your opinions on how you view ROI.

For example, if I'm creating a website and it costs $8,000 for example. My thinking is that if I just sell $8000 of products on there, I'll recoup the cost of the website. However, shouldn't I be looking at the net profit from that sale not just the $8000?

Similarly in real estate, if I want to build a ADU in the back of my house and it costs $100,000 but rents for gross $24k a year, I'll recoup the cost of the build cost in 4 years. However, when making these decisions, how do we know upfront what the net rent is going to be after depreciation, taxes, expenses, etc to determine an accurate break even amount? I'm sure after calculating this it won't be 4 years?

Looking forward to everyone's insight on their thought process.

[Mack Benson]

Calculating the ROI is going to be all about the math, much like most things real estate. The basic formula would be NOI / Cash invested. For your example we'll need to make it more complicated an make some assumptions along the way.

Scenario 1 Assumptions

1. 1 - You pay out of pocket the entire cost to build your ADU, cash invested $100,000
2. 2 - The value of the property does not justify the fees associated with cost segregation so you will use a 27.5 year  depreciation schedule. On a value of $100,000 assume the annual depreciation is $3,636
3. 3 - Your property taxes will increase by adding an ADU to your property, this is difficult to assume an amount without knowing the market so I will bake it into the expenses
4. 4 - Your utility cost will increase as well, again we won't know how much so additional assumptions will be made
5. 5 - We assume you will self-manage the rental so the expenses will be lower but we will include the management fee in the total expenses.
6. 6 - We will assume a 45% expense rate from your gross rent collected. I am using a lower percent than normal because the ADU is newly built and I assume you will not have much in the way of maintenance costs and you will use more efficient fixtures to reduce your utility cost. In reality you may be able to lower your expenses even more but I'll let you calculate that
7. 7 - Rental income is $2,000/month
8. 8 - I'll include a vacancy of 5%
9. 9 - CapEx will be included in your normal expenses
10. 10 - I'm not a CPA but the number I use to estimate taxes is 30% of income and that's what I'll use on your cashflow to estimate the tax liability

Scenario 2 Assumptions

1. 1 - Same assumptions as scenario 1 but rather than paying out of pocket you get a loan. Assume the amortization is 25 years, interest rate is 4% and the equity down is 20%.
2. Loan amount = $80,000
3. Monthly Payment = $422
   
4. Annual Payment = $5,064
5. Cash invested = $20,000

Income:

• Gross Rent - Vacancy = Gross Income = $24,000 - 1200 = $22,800

Expense:

• 45% of Gross Rent = $24,000 * 45% = $10,800

NOI:

• Income - Expense = $22,800 - $10,800 = $12,000

Tax estimate = $12,000 * 30% = $4,200, depreciation was $3,636 so tax estimate is $564

Cashflow after taxes = $12,000 - 564 = $11,436

Of your initial investment of $100,000 your cashflow is about $11,436.

For your return we'll take your cashflow and divide it by your investment. In scenario 1 you don't have a mortgage so your return will be $11,436/$100,000 = 11.436%. It will take about 9 years to make back your capital assuming nothing changes. 

In scenario 2 you have a mortgage but your initial investment was only $20,000. The mortgage payment is $5,064 per year so your cashflow before taxes is $12,000 - $5,064 = $6,936 and your estimated tax liability is $6,936 * 30% = $2,080 but your depreciation is $3,636 so your tax liability is -$1,555. We will keep the cashflow of $6,936. In this case your return will be $6,936/$20,000 = 34.68%. It will take about 3 years for you to make back your capital assuming nothing changes.

I made a lot of assumptions but this would be the general process I would go through while contemplating the investment.