Real estate investment is believed to be the easiest way to earn passive income, provided you made an informed decision. This is why most people are willing to take the risk of investing their savings into the real estate priorities.
Sooner or later after making the investment, an investor always feels the need to assess whether he has made a good investment or not.
This article tells about how to evaluate your real estate investment and rate it good or bad.
Some Useful Terms
Before we delve into the analysis, you must be familiar with some widely used terms:
- Initial Investment is the amount an investor pays at the time of purchase of a property, usually as Downpayment or Upfront Payment. The initial investment will also include the transfer fees, commission, or any other charges required to complete the transfer of the property in addition to the price.
- Total Investment includes the entire amount that has been paid by the investor towards a property till the time of analysis. In case of a property purchased on installments, it will include the installments paid till date along with the downpayment and any other charges.
- Current Market Value is the approximate value of an asset that you will get if you were to sell your property or your share in property. The current market value can be higher or lower than the actual price the owner had paid to purchase the asset.
What is the Criteria to evaluate your real estate investment?
The basic criteria to evaluate an investment is to measure the profit (or loss) you have earned from that investment. The formal term used for profit is “Return on Investment” (ROI).
Return on Investment is the income or profit you have earned on your total investment. The formula to calculate the ROI is as follows:
Return on Investment = [(current market value – total investment)/ total investment] *100
The difference between the money you have invested in your property and how much it is worth is a clear indication of how much return you have earned.
For example, you bought a property for 1,000,000 and you sold it for 1,250,000. Applying the above formula, you earned a 25% return on your total investment.
We have conducted a little case study to help you understand how you can evaluate your investment.
Person X booked a plot file in Capital Smart City at a downpayment of Rs. 424,500 while the total price was 4,245,000. Then, he also paid the confirmation fee which was Rs. 424,500 and 10,000 in membership fee.
This makes his total investment Rs. 859,000.
The investor decided to sell the file after one year at a profit/on of 80,000. Thus, he received Rs. 939,000 in total.
The return on investment will be 320,00/859,000 which is almost 9.3%. So, he earned almost 9.3% return on his total investment of 859,000.
Notice that the total investment, in this case, is 859,000 not the total price of the plot.
Investor Y purchased a 1 Kanal plot in DHA Multan at full price. The initial market price of 1 Kanal Plot in DHA Multan was 45 Lac and has increased to 55 Lac within 1 year. He also paid 50,000 as transaction costs including commission and applicable taxes.
The total investment in this case will be 45 lac 50 thousand (4,550,000).
Moreover, the profit will be 9.5 lac (i.e 55 – 45.9). Thus, the return on his investment is 9.5/45.5 = 20.8%.
The investor here has earned a profit of 9.5 lac on his 1 year investment which is approximately 20.8% return.
Is it a good return or bad?
Having calculated the ROI (return), the next step is to determine whether it is a good return or not. Read on to learn about the criteria to rank ROI as good or bad.
We have discussed a few famous methods below that are used worldwide to evaluate your investment.
1. Compare with benchmark average market return of real estate investment
On average, an annual return of 10% is considered a good average profit in the real estate sector in Pakistan. Investments that are able to earn near 10% price appreciation in a year are considered very good.
Now if you compare your returns with the average market returns on the real estate investment, you would know whether your investment was good or not. If your returns are higher, equal, or even nearly equal to the average returns, this would mean that you have done well on your investment.
Under this criteria, person X in Case 1 earned very decent return while person Y in Case 2 earned a highly lucrative one.
2. Compare with average current market return of alternative investment
Another method to evaluate the real estate investment is to compare your returns with the average current returns on some alternative investment such as the average return on shares in the stock exchange or fluctuations in the prices of gold.
This method also allows you to account for the prevailing market conditions.
For example, suppose that the bank is offering 7% return on bank deposits, the stock market index increased by 5% while the USD appreciated by 12% this year.
In that case, the return on investment of Person X will be considered exceptional as it performed way better than the market.
3. Benchmark Rental Income
Buying a rental property that can be a good source of passive income is another popular real estate investment. Rental income is famous for evaluating the investment in real estate properties.
In Pakistan, a good real estate investment is the one that lets the owner earn 0.5% percent of the upfront cost, including any initial renovations and the purchase price.
Globally – particularly in developed countries – 1 percent rule is a popular method for evaluating rental properties according to which a good rental property should bring around 1% in monthly rental income.
However, this percentage reduces to 0.5-0.6% for rental properties in Pakistan.
Hence, a good investment in rental property is the one that brings 0.5% to 0.6% of property value as monthly income. However, this is not a fixed percentage as it varies with location, project, and other factors also come to play a role in determining the monthly income.
For instance, if you own a property that cost you 7,500,000, it would be considered a very good investment if you are able to earn from it a rental income between 37,500 to 45,000 per month.
What factors make an investment good or bad?
There are no hard and fast rules to evaluate a real estate investment as each investment is different in many aspects.
In order to analyse your ROI, the return on your real estate investment, there are a number of key factors that you must keep in mind.
1. Type of Project:
The quality of project, repute of the developer and project features such as location play a huge role in the performance of the property.
For example, highly esteemed projects are likely to earn higher returns due to high demand, faster construction and branding efforts.
2. Project Life Cycle:
A real estate project goes through several stages in its life cycle.
The initial stage enjoys a hype in the market due to marketing efforts by the developers.
The demand during development or construction is usually stagnant and enjoys occasional hype and price spikes with each milestone.
Similarly, the demand and price after development or possession also increases as a new milestone is achieved in the occupation of the project.
3. Economic Conditions:
Oftentimes, the performance of real estate properties is also affected by the prevailing market conditions.
For example, uncertainty or political instability tends to slow the market down where there are less number of buyers and a lot of sellers. Click here to Read our in-depth article on Political Instability and its effect on Real Estate Market.
Similarly, if the country’s economy is growing, then the real estate properties would also earn good profits, and vice versa.
Many naive investors harbor hopes of earning profit in unrealistic figures. An investor should always see the market trends and criteria to evaluate his investment rather than dwelling on their unrealistic standards. Just keep the above mentioned factors in mind while you evaluate your real estate investment. Feel free to contact us if you have any questions!