Making Better Business Decisions using ROI.

Jeff

Jan 3, 2024 • 5 min read

This article aims to help you understand the drivers behind the financial return for your business or a new project using the Return on Investment ("ROI") metric. I will assess an investment property as an example (as Aussies love their investment properties) to bring the concepts to life, however, you can apply this thinking to any financial problem your business is facing. Before we get into the returns, we need to define a few important terms.

Investment/Equity

The investment or equity (used interchangeably) is calculated by the difference between the Property Value and the debt you owe on your financing such as a mortgage. In the beginning, this represents the amount of cash you have put into the property and will include the deposit and the component of your mortgage repayments that is above the interest.

Return

A return is how much cash you get from making the investment. For an investment property, this primarily comes in the form of rent from leasing it to a tenant and any appreciation in the value of the property, which I will call Capital Gains. However, this is offset by costs of running the property like the interest you pay to the bank, insurance and property manager fees. All of this summed together, which I will refer to as the Net Return.

Return on Investment

The investment you make into your investment property is the equity. By dividing your return over your investment, you can work out a number that you can easily interpret and compare. For example, if you made $1,000 over a year, that seems pretty good. However, if you needed to invest $1,000,000 to make that $1,000, then you’ve made a return of 0.1%. If the interest in the bank would have been 1.0%, this would not have been great and you would have rather just kept it in the bank. We will call this the return on investment (ROI).

Sources of investment property returns (key formula)

ROI = Net Return / Equity

= Net Return/Property Value * Property Value/Equity (Note: I’ve added Property Value which cancels out)

= (Rent + Capital Gains - Costs)/Property Value * Property Value/Equity (Leverage)

= (Rent/Property Value + Capital gains/Property Value - Costs/Property Value) * Leverage

= (Rental Yield + Capital Growth - Costs/Property Value) * Leverage

This shouldn’t make much sense to you yet. I want to set up all the key formulas up front which the rest of this article will take you through. This can be calculated over any time period, however, it is standard to use a period of 1 year.

Rental Yield

Rental Yield is calculated as Rent/Property Value. Take an example of a $500k property receiving $500/week, which translates to $26k/year. Rental Yield = $26k/$500k = 5.2%. Note this is a good rule of thumb for Australia - if the weekly rent is the same number as the first 3 digits, then the Rental Yield is roughly 5%. So to take another example to reiterate, a $750/week rent on $750k property is 5.2%.

Doing a quick Google, I can see that the highest rental for suburbs around Sydney and Melbourne are almost 5%, and 7% near Brisbane.

Capital Gains

When a property goes up in value, that is called Capital Gains. So if a $100k property goes up $10k, that's a 10% Capital Gain. Unlike rent, you do not actually get any cash in the bank when you have Capital Gains. So you are relying on the rent to cover the costs I’ll cover below.

Capital Gains vary greatly by city and type of property. I’ll refer to the economic theory of demand and supply here - the more people want the property and the less supply of the property, the more they will drive prices up and vice versa.

Costs

Running an investment property will have costs, so it will be up to you to decide which ones you think are worth paying for. Below is a list of some common costs and a justification for why I have chosen to pay for them. To provide you with some context, I will use the actual numbers that I paid below for running my 2-bedroom apartment investment property in Sydney, Australia in 2022 as a guide. Note, however, that your circumstances will likely be different, resulting in different figures.

Standard tenant contracts will have the landlord cover the council, water & sewage and strata fees (exceptions apply). It’s possible for you to contract out of this in your agreement, but this is pretty standard. This was ~0.7% of Property Value.
Mortgage, paying an interest rate that translates to ~2.4% of property value. I have a mortgage because the property is expensive and Sydney, and get Leverage which I expand on below.
Property manager fees, paying ~0.2% of Property Value. The property manager is the person who deals with the admin around the property. They help you find and screen a tenant, make sure all your bills are paid, chase up on rent and take any questions/complaints from the tenant. I want my investment property to be relatively hands-off - I just want to receive my rent in my bank account each month. I don’t want to take calls at 1 am from my tenant that the plumbing isn’t working and his toilet is clogged. That’s what my property manager is for.
Landlord insurance, paying ~0.1% of Property Value. Buying a property is very expensive and paying for insurance means you sleep soundly knowing that if the tenant (or their pet) does screw up your place, you have someone covering for (most) of the costs.
Capital expenses - you know when I said I didn’t want to take the clogged toilet call? Well, you’re still on the hook to fix up the property and make sure it’s to the quality that you agreed when the tenant originally leased it. So when these things happen, you’ll need to cover this. I won’t include a number here to keep it simple, but you should definitely budget for this to happen.

Net Return

Assuming I get a Rental Yield of 4.6% (the best near Sydney from above) and get a capital growth of 4%, the sum of all my costs is 3.4%. So the Net Returns is 4.6% + 4% - 3.4% = 5.2%. Note this is just an illustrative example as other factors are not included such as tax and other costs. Now, 5.2% is ok, but that’s not great for dropping investing so much? So why is it that there are so many property investors? Enter Leverage.

Leverage

This is calculated as Property Value/Equity. So if I have a $100 property and I’ve put in $20 for the deposit, then my Leverage is $100/$20 = 5. This is very closely related to the concept of LVR (loan to value ratio) which you will hear the banks use. In the same example above, as my purchase price was $100 with a $20 deposit, then I would have needed an $80 loan. The LVR is calculated as Loan/Property Value, so in this case, it would be $80/$100 = 80%. So, because property value = loan + equity, therefore, Leverage = 1/(1-LVR).

However, I find it easier to talk about Leverage. At an 80% LVR, you will have Leverage of 5. So this means that any Net Return you make will be multiplied by 5 - so the 5.2% Net Return from above, results in an ROI of 26%. However, it’s important to note that Leverage is a double-edged sword as it also applies to negative numbers. A -5.2% Net Return, will result in an ROI of -26%. This means you have lost more than a quarter of your original investment!

If your mortgage is structured as a Principal & Interest, then your monthly payments will reduce the size of your loan, hence reducing your leverage. This potentially lowers your returns which is why some people choose to keep their mortgage interest-only.

Key takeaways

Return on Investment (ROI) = Net Return (Rent + Capital Gains - Costs) / Equity (cash you’ve invested).
Rental Yield is the annual rent you receive divided by the Property Value.
Investing in property means you can use Leverage which will multiply your returns. However, it’s important to note that it also multiplies your losses.