How do you calculate the ROI on your rental properties?
Whether you’ve just bought your first rental (or you’re thinking about buying it) or you’ve just bought your hundredth but you’re wanting to better understand how ROI works for rental properties, you’ve come to the right place.
We’re going to explain everything you need to know to calculate the ROI of a rental property.
What is ROI on a Rental Property?
ROI stands for return on investment and, for rental properties, it refers to the amount of money you make back from your rental property investment.
The basic formula for this is pretty simple.
ROI = (Rental Property Income – Cost Of Investment) x 100
This will give you, as a percentage, the amount of money you’re making back on your investment.
Well, not necessarily. Calculating ROI can get pretty complicated when it comes to rental properties depending on how “in the weeds” you want to get. You can account for equity, appreciation, repair costs, holding costs, and lots more. In a moment, we’ll show you how to calculate ROI the simple way… and the more in-depth way. Both have their uses.
Why is Calculating ROI Important For Rentals?
You’re investing in real estate to make money, build wealth, and create freedom for you and your family.
ROI is an important metric for determining the potential profitability of a rental property before you buy it. Knowing these numbers will help you determine how much you should pay for the property in the first place and how much you can expect to make from the property in profit every month (as well as over the long-haul).
You don’t have to obssess over every penny, but it’s important to know what you’re getting into and to make sure that your investments are at least breaking even.
6 Different Ways To Calculate ROI on a Rental Property
Now let’s talk about the different ways you can calculate ROI on a rental property.
The method you use will depend on how deep you want to get — or what costs, exactly, you’re most concerned about.
1. Cash Flow
You don’t have to listen to many real estate investing podcast episodes to come across the phrase, “Cash flow is king.” It’s a mantra in the real estate investing world for good reason.
Because positive cash flow is where money is made and future investments are made possible.
Calculating the cash-flow ROI on a property is pretty simple.
Imagine you buy a property with financing. Your monthly mortgage payment is $1,200. You plan to rent the property for $1,500 per month. The simplest way to look at this is that you stand to make $300 in cash-flow every month from the property so long as it’s filled with tenants.
Of course, we’re not factoring in your down payment, equity, repair costs, holding costs, or appreciation.
But this calculation is quick, simple, and gives you a high-level view of how much cash will flow to your bank account every month.
2. Cash-on-Cash Return
Cash-on-cash return is a popular metric amongst commercial real estate investors. But it can also be a useful calculation for rental property owners that are using financing to buy rentals.
Whereas traditional ROI calculations show the total return on investment, cash-on-cash return shows the investor’s actual annual cash flow income relative to the original amount of money invested in a property.
The calculation is fairly straightforward: you take your average annual pre-tax cash flow and divide it by total equity invested.
This gives you a percentage that tells you how much money you made relative to your cash investment — it’s a measurement of cash-flow rather than merely profitability.
For example, imagine that you purchase a rental property for $500,000 using financing. Your down payment is $100,000 and you borrow $400,000 from the bank. You also have to pay $10,000 in closing costs, insurance, and maintenance costs.
After one year, you have paid $15,000 in loan payments and about $5,000 has gone to the principal of the loan (nevermind that those payments were actually be made by your tenants — it’s all about the cash-flow with this metric). You sell the property for $600,000 a year later. Your total cash outflow, then, was $125,000 and your total cash inflow, after repaying the loan, is $205,000. We can then calculate the cash-on-cash return as follows: ($205,000 – $125,000) / $125,000 = 64%. This is a great return on your investment!
It’s important to note that cash-on-cash return can be very different from the total returns you may expect. Total returns include capital appreciation, loan principal paydown, and other factors. While the cash-on-cash return is a great way to measure and compare potential investments, it’s also important to consider the potential total returns of any real estate deal before signing on the dotted line.
3. Cap Rate
Cap rate is another metric used to evaluate real estate investments. It stands for Capitalization Rate and it measures the potential return of an investment based on the income it generates. It’s particularly useful for investors who plan to purchase a property and rent it out. The cap rate is calculated by dividing the annual net operating income of a property by its current market value. This ratio can then be compared to similar properties in the market or used as a forecasting tool.
For example, if you purchased an apartment building for $1 million, and the net operating income of the property was $100,000 a year, then your cap rate would be 10%. A higher cap rate generally indicates a more attractive investment opportunity. It’s important to note that cap rates can vary significantly depending on location and other market factors.
It is also essential to take into consideration ongoing expenses associated with a real estate investment, such as property taxes, insurance, and maintenance costs. Doing so will give a more accurate picture of the potential return on investment.
4. Net Operating Income
Net operating income is easy to calculate and gives you a general idea of how much money you will make from a property. To calculate the net operating income, subtract all of the expenses associated with owning and running the property (mortgage payments, taxes, insurance, repairs and maintenance, etc.) from its total annual income. This number is your net operating income for that year. For example, if a property brings in $20,000 a year and has expenses of $15,000 a year, its annual net operating income is $5,000. Knowing this number will help you determine whether or not the property is worth investing in.
5. Home Equity
One of the biggest benefits to buy-and-hold investing is that someone else, your tenants, pays your mortgage payments for you and builds your equity. In other words, you basically build equity and benefit from appreciation for free (not counting your initial investment, of course).
The equity you’ll gain is an important consideration when it comes to calculating the ROI of your rental property. To calculate the equity you’ve gained, subtract the amount of money you owe on the mortgage from the current market value of your property. This will give you a rough estimate of how much your property has appreciated over time and thus how much equity you have built or lost.
Knowing your home equity will help you make smart financial decisions.
6. Internal Rate of Return
(IRR) is another important metric you should consider when evaluating the performance of your rental property. It is a measure of how much money you will earn, expressed as a percentage, on each dollar you invest in the property over its lifetime. Whereas ROI looks at how much you have earned in the past, IRR predicts the future. To calculate the internal rate of return, you will need to know the total amount of money invested in the property and its current cash flow. Once calculated, compare your IRR to other investments. If it is higher than other options, then you have made a good decision when investing in this rental property.
Calculating ROI With Cash Purchase Vs. Finance Purchase
When buying a rental property, you can choose to do so with cash or on credit. The return on investment (ROI) will be different depending on which option you select. A cash purchase will produce a higher potential ROI, but will cost more upfront and involve more risk. Financing your purchase can generate a healthy ROI and reduce risk.
Your ROI will be different based on how you purchase the rental property.
To calculate your ROI, look at the total cost of a cash purchase versus the ongoing costs associated with financing. Subtract these from likely rental income in order to get an indication of potential return. Also consider additional expenses such as insurance, maintenance, mortgage, and taxes. By comparing different scenarios you can determine which option is best.
Considering The Length of The Mortgage Loan Term…
If you do decide to get mortgage then the length of the loan term is an important factor to consider. A shorter-term loan offers a higher monthly payment and less interest over time (but a faster pay-off period), while a longer-term loan will have lower payments but charge more interest overall. Weighing these two options against one another can help you find the best solution for your situation. But generally speaking, savvy real estate investors will opt for a longer loan and lower month payments to generate more postive cash-flow.
But Not All ROI’s Are Tangible…
What’s the value of learning how to invest in real estate?
Or having the opportunity to make passive income?
Or building a business that lets you leave your day-job?
The ROI of these intangibles may not be immediately obvious, but they are an essential part of a successful real estate investing strategy. It’s important to think beyond the immediate financial return on investment and consider what other benefits you’ll gain from your investments. Understanding the bigger picture will help you make better decisions that will help you reach your goals faster.
Whatever your individual ROI goal is, it’s important to make sure you always keep it in mind when making investment decisions. You don’t want to be short-sighted and miss out on opportunities for long-term growth or make hasty decisions that can lead to losses.
What is The 2% Rule in Real Estate?
The 2% rule is a simple way to evaluate potential rental properties to determine whether they are a good investment. The rule states that the monthly rent for a given property should be at least 2% of the purchase price. For example, if you purchase a property for $200,000, then your expected rent should be at least $4,000 per month in order to meet the 2% rule. It’s meant to protect the investor from losing money. But it doesn’t really work. In fact, we wrote an entire article explaining why it doesn’t work. Check out our 2% rule article here.
What is a Good Rate of Return For Rental Properties?
A good rate of return for rental properties depends on a variety of factors. The most important factor is the amount of cash flow generated by the property. Generally, you should be looking for returns that are higher than what you’d get from other investments like stocks and bonds. A typical goal is to achieve a cap rate between 6%-12%. Additionally, you should also consider the potential appreciation of the property when determining a good rate of return. Ideally, you will achieve both cash flow and appreciation to maximize your returns.
Finally, it’s important to factor in any additional costs or expenses associated with owning the rental property. This includes things like repairs, maintenance, insurance, taxes and other fees. By taking all of these factors into account, you’ll be able to determine a rate of return that’s right for you.