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 in real estate investment.
In this comprehensive guide, we delve into the depths of rental property ROI, unveiling its potential to unlock real estate investment success.
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Return on Investment (ROI) is a metric for evaluating the profitability and effectiveness of an investment, indicating the extent to which investment 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 calculations such as whether you make a cash purchase or finance the property through a mortgage, 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 simple ROI calculation, the capitalization rate (cap rate), and the cash-on-cash return. The method you choose will depend on factors such as the initial amount borrowed and the financing method used to purchase the property.
For rental properties, ROI is typically calculated by subtracting the annual operating costs from the annual rental income 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 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, including how much cash you invest, how much rent you charge, where you invest and local fees such as property taxes, property management fees, and financing method.
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 9.2%.
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%.
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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 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.
Evaluating the potential returns helps determine the profitability of an investment. If, at any point, it becomes evident that costs and expenses will exceed the expected 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 generate passive income, which is why it’s important to know how to calculate ROI for your property. You can accurately calculate the ROI percentage per property by running reports to access your financial data or use the Landlord Studio in-built cash flow calculator to provide all the numbers you need to see how profitable your rental is.
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 then 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.
By leveraging Landlord Studio's features, such as accurate income and expense tracking, detailed real estate reporting and analytics, and maintenance management, we give you all the tools you need to optimize your rental property management and maximize your ROI.
Start using Landlord Studio today to take control of your rental business and achieve your real estate financial goals.