Question

A house, which you could rent for \(\$ 10,000\) a year and sell for \(\$ 110,000\) a year from now, can be purchased for \(\$ 100,000\). What is the rate of return on this house?

Short answer

The rate of return is 20%.

Step-by-step solution

Understand the Problem

We need to calculate the rate of return for a house bought for $100,000, rented for $10,000, and sold for $110,000 after one year.

Calculate Total Earnings from Rent and Sale

Add the rent income to the sale price. The total earnings in a year are $10,000 (rent) + $110,000 (sale price) = $120,000.

Determine Initial Investment

The initial investment is the purchase price, which is $100,000.

Calculate Net Income

Net income is the total earnings minus the initial investment. So, the net income is $120,000 - $100,000 = $20,000.

Calculate Rate of Return

The rate of return is calculated as \( \frac{\text{Net Income}}{\text{Initial Investment}} \). Here, it is \( \frac{20,000}{100,000} = 0.2 \), or 20%.

Key concepts

Investment Calculation

Investment calculation is a key part of determining the profitability of an investment. It involves figuring out how much return you will get relative to the amount of money you initially put in. In this example, we need to calculate the rate of return on the house. First, assess all sources of potential earnings from the investment.
This house provides two streams of income:

• Rental income of $10,000 per year
• Sale price of $110,000 after one year

Start by calculating the total earnings. Add the rental income and the sale price to find the overall earnings from the investment. Here, that total is $120,000. Next, look at the initial investment, the amount spent to purchase the property, which is $100,000.
The net income is then calculated as your earnings subtracted by the initial investment cost. In this example, the net income is $20,000. Finally, determine the rate of return by dividing the net income by the initial investment; this shows the profitability of your investment in percentage terms. Here, it results in a 20% rate of return. This means for every dollar invested, you earn 20 cents of profit.

Real Estate Economics

Real estate economics involves understanding the factors that impact property values, rental income, and overall market trends. The calculation of the rate of return on a real estate investment also depends on these factors. Several components influence how much you can earn from a property. These include location, current market demand, and economic conditions.
A favorable real estate market can increase the value of investments significantly, maximizing both rental yield and sale price potential. In our example, buying a house for $100,000 and then renting and reselling it allows the investor to capitalize on rental income and potential appreciation in property value.
Consider market trends when deciding whether to rent or sell a property. If the market is experiencing high demand, it might be beneficial to maintain the property longer to appreciate its value further. On the other hand, short-term strategies can be effective if quick returns are preferred or if market conditions are less predictable. In this scenario, the decision to rent and sell within a year was likely a calculated move to realize immediate profits.

Financial Literacy

Financial literacy is crucial for making sound investment decisions, such as understanding the rate of return. It equips investors with the knowledge to evaluate risk and calculate potential rewards accurately. By mastering these concepts, individuals can effectively manage personal and investment-related finances.
In our exercise, financial literacy helps distinguish between mere potential returns and actual profit outcomes in a calculated investment. A strong foundation in financial literacy involves:

• Comprehending different types of income (e.g., rental versus capital gains)
• Understanding taxation and the impact it might have on returns
• Being aware of inflation and its long-term effects on purchasing power

Gaining insights into investment metrics such as the rate of return or ROI helps investors measure and compare the effectiveness of different investments. These skills support informed financial decisions, ensuring improved financial well-being and growth over time. Building financial literacy is a continuous process that enhances the capacity to interpret and respond to economic changes productively.