Return on Investment (ROI)

One man's return on investment might be another man's loss.

ROI
Return on investment (ROI) is a standard measure in financial terms to measure and determine the effectiveness or profitability of an investment. It measures the amount of return as a percentage of the initial investment required. So if I invest a million Rands into an account that pays me 10% interest p/a, my return would be 10%. Similarly, if you purchased a house and rented it out for R8333.33 per month, or R100 thousand per year, your return would be 10%.

Example
Now things get slightly more complex. When I purchase that house for R1 Million, I don't pay cash, but raise a bond over the property and only fork out the transfer fees. This would amount to approximately R80 thousand (transfer tax and conveyancing fees). My bond repayments would be R10 thousand per month or R120 thousand in the first year. Together with the initial cost of R80 thousand we have an investment of R200 thousand rand in the first year. If rented out at R8333.33 per month I would offset that R100 thousand income against my cashflow. The ROI would show R200 thousand generates a R100 thousand return or 50% in the first year.

This example is relatively simplistic and leaves out rates and taxes and the possibility of Capital Gains on this property (as well as the tax necessary on the income), the point is made that the ROI of investing in property can be quite high when coupled with gearing or leveraged finance.

Don't mistake ROI with cashflow though. The cashflow in the above example is the difference monthly or yearly between the income and required expenditure. R10 thousand bond repayment and R8 333.33 rental income makes for a minus R1 666.67 monthly cashflow.

Beware the Adverts
Have you seen any adverts that quote a ROI as justification for investment in property? I recently saw one in an up-market magazine and it quoted a 27% ROI. I had a closer look at the advert. It was for a holiday property and required a R400 thousand investment for a share in a property syndication scheme. This entitled the owner to 5 weeks ownership per year. This property could be rented out. The advert quoted the ROI as R3000 x 7days x 5 weeks = 27% ROI and said that 'Thus initial investment paid off within 3.7 years'. Attractive.

What the Advert doesn't say.

  • Admin Fees: The advert doesn't mention administration and management fees that normally amount to 30% in these schemes.
  • Occupancy rate: The 'rented out' or occupancy of the home was calculated at 100% too. An occupation of more than 50% would be quite good.
  • Furnishings: Does the initial investment also include furnishings, like beds, linen and crockery? All this will be necessary if you plan to rent out the unit.
  • Levy: The advert doesn't mention anything about a levy.

Making some of my own assumptions, my calculations on the property showed the ROI at a more realistic 10%. This isn't a bad ROI but it isn't as spectacular as the 27% quoted. If the marketers were happy to misdirect the public with these figures what else might they do in order to sell this development?

It is important to question figures quoted and make sure that the assumptions are realistic. Just a last thought, if I invest R1 Million into an investment and I get 0% interest or return, what is my ROI?

Article by : Dave Welmans - (www.thepropertygame.co.za)