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Learn this fundamental calculation – Return on investment

Enhanced Transcribe:

Hey folks it’s Dr Ro here, I hope you are well. 

It’s a beautiful sunny morning coming up to March, spring is on it’s way and I wanted to tackle a question that still comes up regularly. Whether you’re just getting into property or you are brand-new to this, by the way this is a calculation that can be applied to all types of business. But I’m going to apply it here to the relevance of property is return on investment. 

Just to help you try to understand this when you put your money in a bank let’s say you £100,000 in the bank and the bank talks to you about the interest rate you’re going to get, that is your return on your money.

So, let’s say for the sake of argument you put £100,000 in the bank, leave it for a year, at the end of the year the bank gives you back £100,000 and £1,000, probably less than that but let’s say £1,000. You’ve earned £1,000 on a £100,000 investment.

Your return on your investment of £100,000 is £1,000, you’ve earned £1,000 as a return on the original investment of £100,000. So let’s now take that and apply that to property investing. Return on investment is equal to the profit you made divided by the cash invested.

How it is typically done it’s calculated on an annual basis; in reality this is a return on investment on cash invested over the time period in which you invested that money and made profit.

One could argue that the same £100,000 put in the bank over a year makes you £1,000 return on investment. If you put the same £100,000 into a property deal and made £30,000 profit that would be a 30% return on investment if it took a year that would be a 30% over the same time period. 

Some people will say what if it takes six months to do it? Then you’ve basically made 30% return in six months, so you could extrapolate that. In other words extend that out for the year and say I’ll do two projects like that; I could make 60% return on investment. Essentially it’s the return of your cash in terms of a profit in terms of a given time period.

When it comes to property there are a few other things we need to consider. So I am going to share with you what I’ve written down here, what things you need to take into account when it comes to projects? This is the stuff people tend to forget, I’m going to break them down here.

We’ve got purchase costs, that is the cost associated with buying the property. So from the minute you start the process think about all the costs involved, do you need to engage a surveyor? If you do fantastic, maybe a structural survey or a normal survey. But remember there are other surveys like with this house we had to have surveys of asbestos, that was part of the works. But in the purchasing process we have nothing associated with the purchase of the property. 

So list those out.

Make sure you’ve allowed for all of that because it’s profit divided by cash invested. What some people do is when they’re doing the calculation they’ll actually forget some of those costs and of course they’re real return on investment may have been lower because they didn’t assume or take into account the cost. 

Entry costs might be slightly different to purchase costs, you may have some other entry costs going into this. What I’m trying to say is that anything you can think of that you can pull together; it might be that you had to pay someone to come out and visit the property with you to do an assessment. It might be that you had a bat survey done because there’s issues with it being an old listed building. 

The key thing is just list out everything. I’ve got my work, the cost of all the renovation works on the project. A lot of people take the works while they’re on the project but I would say any works leading up to it, this property needed groundworks.

Then there is the main renovation work and then maybe some follow-up afterwards, there might be some clearing up, you might need to get skips in to finish up some things. There might be some finalising whatever it is you’ve got to allow for all of your costs.

Where I believe people get return on investment wrong is they tend to underestimate their costs going into the project and out the project. Think of it as a package, everything goes into that package, that’s all your costs. Legal fees so that would be your personal legal fees.

For example, yesterday I did a video where I was talking about the fact that I was doing a refinance. There are legal fees going into projects and legal fees coming out of the project. There will be the legal fees with the solicitors dealing with the actual project but then you might have to take on a second lawyer to give you independent  advice if you’re doing personal guarantee through a limited company. Then you’ve got to seek advice from an independent lawyer and then they will charge additional legal fees.

Every single legal fee associated with renovation and if you’re selling it and all the possible refinancing of as well. Finance costs, we’ve got purchase, entry works, legals, finance costs. Your broker may charge a fee, all brokers will get a fee from the bank, but your broker may charge a separate fee. There may be other fees associated, for example, they might charge you administration fees and this will be the bank. You can pay the fees upfront, or you can add those fees to the actual mortgage and in that case you’ve got to allow for that as well when you’re doing your final calculations. 

Finally I’ve got holding costs there. Holding costs are the costs associated with holding the property while the renovations are going on. Let’s say it is a four-month renovation. You buy the property, there are no tenants in the property and you’ve got a mortgage on it. ;let’s say the mortgage is £500 a month, you’ve got £500 for four, five months or however long the renovation is, let’s say four months. That’s £2,000. 

You’ve also got potentially stamp duty. You’ve also got other things like overhead costs, electricity, gas, anything like that. They are all the costs of holding the property whilst the renovation is going on. So at the end of the project having done it, made it look beautiful you get to a stage where you go right now we are either going to sell the property or we are going to refinance the property.

If you sell the property you’ll get to a point where after the sale, a certain amount of money will drop into your bank account. Now that is the cash back to you. You then have to work out what your net profit is. It might be that out of that money that comes in, you still have to pay people back because you haven’t cleared your costs.

For example, it might be a final refinance cost to pay, might be a few legal fees to pay. There might be something to pay off to the builder having got our money back there are some final works to finish off with.

The real exercise is the final paperwork saying these are all my costs, this was the final sale, this is what I bought it for, profit is that much, minus my costs so my true profit is that much. Then you work out what you put into the project and divide that into the profit i.e. profit provided by cash invested and that will give you your return on investment. 

Hopefully that makes sense. So just get a pen and paper and play with this for example, you buy property for £100,000 you have £20,000 worth of work to do, you have another £5,000 worth of legal and finance costs, so you’re in £25,000. Then let’s say you have some holding costs of £2,500, so £27,500, worth of total cost going into the project and then you sell the property on and you make for the sake of argument, if you made £27,500 worth of profit and all in costs into that were £27,500 then you’ve made 100% return on investment. 

Remember you’ll have had to put money down as a deposit as well so you’ve got to take that into account. Once you’ve been through a few examples it will make sense, the key thing is to get this into a spreadsheet, practice and run the numbers. Your objective as an investor is to decide on your minimum return on investment.

We haven’t allowed for here under financing you’re going to have finance costs to the lender, but you might have angel funding. If your angel has lent you money your cost of borrowing the angel money of course, that needs to be taken into account as well. So that is a cost which ultimately affects your profit, which then of course affects your final return on investment.

That is it for now, Dr Ro signing out.

Disclaimer: This video or written publication does not offer investment or financial advice and nothing in them should be construed as investment or financial advice. Our publications provide information and education only. The information contained in our publications is not, and should not be seen as a recommendation to use any particular investment strategy. Always seek financial advice from an independent financial adviser around your own personal financial situation.

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