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A house bought some years ago for 100K earns 5K each year. That's rent minus costs of ownership (maintenance, electricity, local taxes).

Today that house would easily sell for 150K. The rent and costs are more or less equal. How would I calculate next year's return? Would that still be 5% (5/100) or rather 3,33% (5/150)?

I said to my father, who claims it still 5%, that he's probably right according to some financial formula. I also told him it's not relevant to see it that way.

Consider that house would be sold for 150K, that money was used to invest differently and earn 4% on it. That would be 6K yearly. That's more than the 5K return on the house. The return on the house couldn't have been 5%.

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  • Why is it earning $5K per year over an extended period, rather than increasing as the rent increases more or less in line with inflation? And why aren’t you including capital appreciation in your calculation of the return?
    – Mike Scott
    Dec 25, 2018 at 20:58
  • Yes, capital appreciation should be included probably in calculating the return. General inflation, however, was only a fraction of increase in house value in the last few years. So, let's ignore the latter
    – Christiaan Westerbeek
    Dec 25, 2018 at 21:05

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Which formula you use depends on your reason for making the calculation.

Return on investment is by definition the return on invested capital. That is, you calculate your returns based on what you invested, be it yesterday or 50 years ago.

You might be looking for the capitalisation rate, which uses (current) market values to calculate your rate of return.

Since you aren’t selling the house, the 150K value is just ‘paper value’. Whether house prices go up further or whether they tank, it makes no difference to you capital-wise. Ignoring mortgage-related ‘access’ to equity, you can’t spend any capital appreciation and your bank account doesn’t drop just because of capital depreciation. So it can make sense to use ROI.

On the other hand, you may be interested in the opportunity cost of your investment. The cap rate is more useful when you are comparing your rental returns with other possible investments.

It’s horses for courses. Pick whichever number best represents the information you want to know.

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Looking at various reference sources concerning REIT's, investment property is valued at fair-market-value. Then net-asset-value is the fair-market-value minus the mortgage pay-off amount. Now I don't know where to get the fair-market-value number except from the tax assessor's office.

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But return-on-investment could use the cost of the investment property. Or I suppose that a yearly return-on-investment could use the fair-market-value of the investment property. If a yearly return-on-investment is accounted with the net-asset-value of the investment property then the effects of loan leverage are accounted.

However, profit-margin is the net-income divided by the rental-revenue and so in this subject case here, the profit-margin is zero percent. Also there is no income gain from the rise in property value but only a gain in book value.

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Furthermore, REIT's exclude accounting of depreciation to arrive at funds-from-operations. Actual net earnings would include accounting of depreciation but since the property is expected to rise in the future then the only real issue is renovation. But renovation is always accounted. I assume that accumulated depreciation is larger than the cost of renovation.

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  • "Now I don't know where to get the fair-market-value number except from the tax assessor's office." An appraisal would be a better source, especially in California, where Propr 13 caps the assessment, regardless of market value. For a rough number, one can simply estimate it from sales of similar houses.
    – Acccumulation
    Dec 26, 2018 at 19:14
  • Certainly, don't forget about appraisals. But my property tax bill gives both a "Fair Market Value" and an "Assessed Value".
    – S Spring
    Dec 26, 2018 at 21:39

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