We take a closer look at how to calculate ROI on a rental property, what makes a good ROI, and why you should care.
Whether driven by long-term retirement goals, saving for significant life events such as starting a family or planning a dream wedding, or simply aiming to generate additional income, the underlying motive for investing remains the same: financial growth.
When it comes to real estate there are a few ways this wealth growth can play out over the long term. For example, if you invest in residential rentals you might set specific goals for appreciation, equity growth, and cash flow. Alternatively, you might look at shorter-term gains with a different investment strategy like BRRRR or fix and flips.
Regardless of the investment strategy you choose, astute real estate investors will evaluate the property's profitability through the lens of Return on Investment (ROI). Understanding the concept of ROI, mastering its calculation specific to rental properties, and recognizing its significance, is foundational for making informed decisions when investing in real estate.
In this comprehensive guide, we delve into how to calculate ROI on rental property, unveiling its potential to unlock real estate investment success.
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Return on Investment (ROI) is a metric used when calculating the profitability of an investment. It gives an indication of how effective leverage is, and to what extent invested funds translate into monetary gains.
Whether investing in stocks, bonds, savings accounts, or real estate properties, ROI provides a standardized measure to assess the viability of allocating funds to a specific investment. In the realm of real estate, where diverse investment avenues exist, understanding and calculating ROI becomes central for informed decision-making.
However, determining a meaningful and useful ROI for investment properties, particularly rental properties, can pose challenges due to the number of variables that impact the calculation. For example, whether you make a cash purchase or finance the property through a mortgage, the ongoing operating costs and expected cash flow, and any potential renovations.
Calculating the return on investment (ROI) for your rental property can be done using several different methods:
The method you choose will depend on factors that we've already mentioned, such as the loan amount and the financing method used to purchase the property.
Calculating ROI for rental properties is normally done by subtracting the total operating costs from the total rental income for the year and dividing this number by the mortgage value (or the remaining loan amount) to determine the ROI. The formula for this calculation is as follows:
This straightforward calculation provides an estimate of your investment gains or losses.
Alternatively, you can use the cap rate method, which is calculated using the following formula.
The cap rate takes into account the net operating income and the purchase price of the property.
Another method is the cash-on-cash return, which is calculated as:
This cash-on-cash formula considers the annual cash flow generated by the property and the total amount of cash invested.
It's important to determine which method makes the most sense for your rental property. If you prefer to use a financial calculator, you can utilize tools like the Landlord Studio rental yield calculator.
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A good rate of return on your real estate investments will vary widely depending on a variety of factors. This includes the property price, how much cash you invest, how much rent you charge, where you invest, local fees such as property taxes, property management fees, and mortgage interest.
Ultimately then, determining a “good” ROI is entirely dependent on your rental business structure and goals. However, with all that being said, as a ballpark figure many investors aim for an ROI between 8 to 12%.
While the equations provided above may appear straightforward, it is important to remember how the variables in real estate can impact ROI calculations. Factors such as repair and maintenance expenses, as well as your financing and leverage, can influence ROI figures. To illustrate, let's examine two examples of calculating ROI for a rental property.
Calculating a property's ROI is fairly straightforward if you buy a property with cash as there are fewer variables to account for. Here's an example of a rental property purchased with cash:
A year later:
To calculate the property’s ROI:
Your ROI was 8.3%.
Calculating the ROI on financed transactions involves more details. Let's consider an example using the same $125,000 rental property as before, but this time with a mortgage:
Considering the ongoing costs of the mortgage:
After one year:
To calculate the property's ROI:
Your ROI is 14.6%.
So, while your cashflow is much lower, your ROI is actually higher because of your ability to leverage - you're getting more bang for your your buck.
Some investors choose to factor in the home's equity when calculating ROI. Equity represents the market value of the property minus the remaining loan amount. It's important to note that equity is not cash-in-hand and can only be accessed by selling the property.
To determine the equity in your home, you can review the mortgage amortization schedule, which outlines the portion of your mortgage payments dedicated to reducing the loan's principal. This contributes to the growth of equity in your property.
In our example, the amortization schedule reveals that $3,300 of principal was paid down during the first 12 months.
When including the equity portion, the new annual return amounts to $8,970 ($5,670.96 annual return + $3,300 equity).
To calculate the property's ROI:
Therefore, your ROI would be up to 23.1%.
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Understanding the how to calculate ROI (Return on Investment) is crucial for real estate investments as it enables informed decision-making. Before making a purchase, it is essential to estimate the costs, expenses, and potential rental income associated with the property. This allows for meaningful comparisons with other similar properties.
If, at any point, it becomes evident that costs and expenses will exceed expectations (meaning you can't achieve your target ROI), one must carefully consider whether to continue holding the property in hopes of future profits, or opt to sell and minimize potential losses.
It’s also important to account for possible vacancies during periods when the property is not rented out and additional unexpected expenses related to owning a rental property, such as repairs or maintenance costs. These factors need to be included in your calculations, as they can significantly impact the overall ROI.
Real estate investors can also explore diversifying their portfolios while maintaining their ROI through pooled investments such as real estate investment trusts (REITs). These investment vehicles allow for broader exposure to the real estate market and can provide a consistent return on investment.
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The goal of managing rentals is to build wealth. This is why it’s so important to stay on top of your finances, to know your figures, and to accurately calculate key ketrics like ROI for your property.
Landlord Studio is the #1 property management and accounting software that gives you all the tools you need to accurately track your finances throughout the year. You can instantly generate any of over 15 accountant-approved reports for nuanced financial detail, and gain quick insights into your portfolio performance through the dashboard.
With accurate and up to date data you can ensure you've got all the numbers you need to maximize your profits and minimize your tax liabilities.
Create a free account today and to collect rental fees, streamline rental property accounting, track maintenance requests, run financial reports, and more — all in one place.
When it comes to ROI, rental properties differ from other investments due to factors like financing and cash payments. Generally, a smaller upfront cash payment with a larger mortgage loan balance can result in a higher ROI, while a larger upfront cash payment with less borrowing leads to a lower ROI. Financing can provide a short-term boost to ROI by reducing initial costs - however, it reduces cash flow.
To obtain an accurate view of your investment portfolio, it's important to adopt a consistent approach when measuring ROI for multiple properties. For instance, if you include the home's equity in evaluating one property, you should consider the equity of other properties when calculating the ROI for your real estate portfolio. This holistic approach ensures a comprehensive understanding of your investment performance.
Finally, by leveraging software like Landlord Studio you gain a range of valuable tools including income and expense tracking, receipts scanner, bank reconciliation, and detailed real estate reporting and analytics which will prove crucial when it comes to optimizing your portfolio profitability.
Start using Landlord Studio today to take control of your rental business and maximize your ROI.