A quick summary
Return on investment is a key phrase in the world of real estate. It’s a vital element to determine the potential success of real estate deals, from fix and flip deals to rental property purchases. Keep reading to find out how to calculate ROI on rental property.
Table of Contents
If there’s one thing real estate investors are looking for, it’s a way to tell whether a deal is worthwhile taking or not. This means being able to tell what the returns on your investment will be, which is where ROI comes in. It’s a powerful tool that both seasoned real estate investors, and those who are new to real estate can use to determine the potential success of a deal on their road to rental real estate. Let’s look at how to calculate ROI on a rental property.
What does ROI mean in real estate?
When you enter the real estate game, the idea is to buy property as an investment and make a good return on that investment. The Return on Investment (ROI) of a property gives investors a good indication as to whether they should buy a property or not, based on the profit margins that they could have on the property.
Simply put, ROI is a percentage which shows how much profit can be made on a property, after the costs have been deducted. ROI is a concrete number based on facts and, as such, is one of the most trusted methods for real estate investors to evaluate the profit potential of a property.
Simple Return On Investment (ROI) Formula
ROI is a term used in accounting to indicate the percentage of invested money that will be recovered once the costs have been subtracted. The ROI equation looks like this:
ROI = Annual Returns / Cost of Investment * 100%
For example: If you bought stock in a company for $2,000 and you sold it a few years later for $2,400, you could work out the ROI using the simple formula above.
- Current Value of Investment: $2,400
- Cost of Investment: $2,000
- ROI = ($2,400 – $2,000) / $2,000 * 100%
- ROI = 20%
While this may seem simple, there are many variables to consider in real estate, which include property maintenance costs, mortgages or rental property loans and so on. So, if you’re looking to calculate ROI on something like a rental property purchase, there are a few ways to go about it.
How to calculate ROI on rental property
Calculating the ROI on a rental property isn’t as cut and dry as the simple ROI calculation mentioned above. There are additional steps, and this is due to the variables that come with a rental property purchase. So, there are slightly different ways to determine ROI on rental properties, depending how the investor is financing the project.
ROI formula for rental property
Rental Property ROI = Annual Returns / Cost of investment * 100%
- We’ll take a look at the rental property ROI formula for cash purchases first. This formula is the most basic and involves dividing the annual return by the total amount that was invested in the property (this includes the purchase price, remodeling and closing costs).
- Next, we’ll look at the rental property ROI formula for investors who financed the transaction with a loan. In this case, you would divide the annual return by the total amount of expenses that you paid for the property (including the down payment, loan payments, closing costs, any remodeling etc).
Step-by-step breakdown of how to use Rental Property ROI formula
Step 1: Determine the Amount Invested
If you buy a property cash, you’ll use the amount you paid for the property and add this to the closing costs and any renovation costs to figure out the total amount which you invested in the property.
If you finance the purchase of a property, you’ll add up the down payment, closing costs and renovation costs to work out your out-of-pocket expenses.
Step 2: Work out the Annual Return
If you buy a property cash, you’ll work out your annual return by adding up the rental that you would receive every year and subtracting the costs every month, which include water bills, taxes and insurance.
If you buy a property through financing, you’ll also take into account the monthly expenses such as the mortgage or loan repayment and interest, along with the usual taxes, insurance and water and subtract this from the yearly rental income to work out your annual return.
Step 3: Apply Rental Property ROI Formula
In both cases, the ROI is then calculated by dividing the annual return by the total investment amount and then multiplying by 100 to work out the ROI in percentage terms.
Rental Property ROI Example
1. Example 1 – Cash Purchase
If you bought a property for $200,000 cash, and the closing costs were $2,000, along with $5,000 for renovations, this brings your total investment to $207,000.
If you’re able to rent the property out for $2,100 per month for a year, and the monthly expenses for water, taxes and insurance add up to $300 per month, your annual return would total $28,800.
- Cost of Investment: $207,000
- Annual Return: $28,800
- ROI: Annual Return / Cost of Investment * 100
- ROI = $28,800 / $207,000 * 100%
- ROI = 13.9%
2. Example 2 – Financed Purchase
If you bought a home for $100,000, of which $80,000 was financed and $20,000 was paid as a down payment by you, with closing costs of $1,000 and a $1,500 remodel, your total investment would be $22,500.
If your monthly rental income was $800, you’d subtract the monthly mortgage or loan repayment from this, as well as the other expenses, let’s say these were $300 and $100 respectively, this means your cash flow would be $400 per month, and your annual return would be $4,800.
- Cost of Investment: $22,500
- Annual Return: $4,800
- ROI: Annual Return / Cost of Investment * 100
- ROI = $4,800 / $22,500 * 100
- ROI = 21.33%
Financial factors that influence rental property ROI
The main financial factors that influence rental property ROI are:
- Property purchase price
- Repairs or renovations that need to be done
- Operating expenses for the property such as maintenance
- Rental income
- Annual expenses like property taxes
- Costs associated with financing such as down payments, monthly mortgage repayments and so on
What is a good ROI for investment property?
There is no hard and fast rule on a good ROI for investment properties because investors have different goals. While some investors are willing take higher risks for greater rewards, others aren’t, so investors will have different ideas what constitutes a good ROI.
However, a general rule of thumb across the board is to match, or exceed the returns of the S&P 500 in the stock market, which averages about 10% for returns. So, an ROI of 10% or more is usually a good baseline to start with.
Lastly, you can also use Cap Rate to quickly assess the potential profitability of a rental property. Cap Rate simply takes the net operating income of a rental property, and divides it by the property value. The higher the cap rate, the more profitable the property. This article explains how to calculate cap rate in more detail.
Closing thoughts
ROI is an important part of real estate investing as a tool for investors to evaluate investment opportunities. Knowing how to calculate the ROI on an investment property will serve you well, not only in the rental property space, but also for fix and flip properties. You can make a more informed decision on a rental property purchase once you know the property’s profit potential.