Rate of Return
The rate of return (ROR), often referred to simply as “return,” is a measure used to evaluate the performance of an investment over a specific period. It represents the amount of profit or loss made on an investment relative to the amount of money invested. The rate of return is usually expressed as a percentage.
The basic formula for calculating the rate of return is:
ROR = (EndingValue − BeginningValue + Dividends or Interest) / BeginningValue × 100%
Where:
- Ending Value is the final value of the investment at the end of the period.
- Beginning Value is the initial value of the investment at the start of the period.
- Dividends or Interest are any payouts received from the investment during the period.
If the ROR is positive, it means the investment has gained value. If it’s negative, the investment has lost value.
Example of the Rate of Return
Let’s explore a more comprehensive example involving a real estate investment.
Imagine you purchased a condominium for the purpose of renting it out. Here are the details:
- Initial Purchase Price (Beginning Value): $300,000
- Closing Costs: $10,000
- Renovation Costs: $15,000
- Total Initial Investment: $325,000
After owning the condo for one year, here’s a summary of your finances:
- Monthly rent collected: $2,500
- Total annual rent (income): $2,500 x 12 = $30,000
- Annual expenses (maintenance, property tax, insurance, etc.): $5,000
- Net Annual Income: $30,000 – $5,000 = $25,000
At the end of the year, similar condos in the area are selling for $340,000. You decide to get an appraisal, and the value of your condo is also appraised at $340,000.
Now, let’s calculate your Rate of Return:
- Calculate your capital gain:
Capital Gain = Ending Value − Total Initial Investment
Capital Gain = $340,000 – $325,000
Capital Gain = $15,000 - Calculate your total gain for the year:
Total Gain = Net Annual Income + Capital Gain
Total Gain = $25,000 + $15,000
Total Gain = $40,000 - Calculate Rate of Return:
ROR = Total Gain / Total Initial Investment × 100%
ROR = $40,000 / $325,000 x 100%
ROR ≈ 12.3%
Your rate of return on this real estate investment for the year is approximately 12.3%.
This example demonstrates how ROR can provide a holistic view of an investment’s performance, incorporating both the operational income (like rental income) and capital appreciation. It also underscores the importance of considering all costs associated with an investment, not just the purchase price, when calculating returns.
