When it comes to boosting your passive income, we bet owning a rental property always comes first on your mind.
Why couldn’t it be?
Buying a rental property always counts as a smart investment. However, before making such a purchase, it’s helpful to know how to calculate ROI on a rental property to make sure it will offer you the desired returns.
In this blog, we’ll break it down into simple steps, so whether you’re an experienced investor or just starting, you’ll be equipped to make smart decisions and maximize your profits.
What is ROI and Why Does it Matter?
ROI, or Return on Investment, is a critical concept in the world of real estate investment. ROI tells you how much money you’ve lost or made on an investment relative to the amount of money you’ve invested.
In real estate, ROI takes into account various factors including the property’s purchase price, ongoing expenses (like property management or maintenance), and the rental income it generates.
Understanding ROI helps you assess whether your investment is increasing the profit or if it’s time to consider other opportunities.
What’s the Importance of ROI in Real Estate?
Now, your question must be, why is ROI so important in real estate?
Well, when you invest in a rental property, you simply invest your hard-earned money in it. And you definitely want to make your invested money work out for you!
ROI allows you to do just that. It helps you determine the profitability of your property by considering all the costs associated with it. Basically, ROI provides you with deeper insight that will help you make informed decisions about your real estate investments.
What’s The Formula To Calculate ROI on a Rental Property?
To calculate the return on investment (ROI) for your rental property there are three different ways to calculate it:
1. The ROI Calculation
This ROI calculation formula will give you an approximate value for your investment losses and gains. You must consider several important factors in order to determine the ROI of your rental property. These factors include:
- Investment Costs: These cover the cost of the property, closing fees, and any initial costs associated with renovating a rental property.
- Annual Rental Income: The annual rental income consists of the total rental income you expect to receive yearly. This is calculating the property’s monthly rent.
- Ongoing/ Annual Expenses: This considers the recurring cost of owning a rental property like- insurance, property taxes, maintenance, and property management fees.
EXAMPLE 1: Simple ROI Calculation
Suppose you have purchased a rental property for $200,000. After accounting for expenses like insurance, maintenance, and property taxes, your total annual expenses amount to $10,000. The property generates an annual rental income of $15,000. To calculate ROI:
ROI = [(Annual Rental Income – Annual Expenses) / Initial Investment] * 100
ROI = [($15,000 – $10,000) / $200,000] * 100
ROI = ($5,000 / $200,000) * 100
ROI = 2.5%
In this scenario, your ROI is 2.5%. This means that for every dollar you invest, you’re earning a 2.5% return.
EXAMPLE 2: ROI Calculation Considering Factors
- Purchase Price: Imagine you’ve purchased a rental property for $250,000.
- Monthly Rent: You rent out the property for $1,500 per month.
- Property Expenses: Your annual property expenses include property taxes ($2,500 per year), insurance ($1,000 per year), maintenance ($1,200 per year), and property management fees ($1,500 per year).
In this scenario, your investment costs consist of the $250,000 purchase price. To calculate your annual rental income, multiply the monthly rent of $1,500 by 12 months, resulting in $18,000 ($1,500*12 = $18,000).
To determine your ongoing expenses, add up property taxes ($2,500), insurance ($1,000), maintenance ($1,200), and property management fees ($1,500), ($2,500 +$1,000 +$1,200 +$1,500 = $6,200) totaling $6,200 annually.
Now, let’s calculate the ROI:
ROI = [(Annual Rental Income – Annual Expenses) / Investment Costs] * 100
ROI = [($18,000 – $6,200) / $250,000] * 100
ROI = ($11,800 / $250,000) * 100
ROI = 4.72%
In this example, your ROI is 4.72%, indicating that for every dollar invested in the rental property, you’re earning a return of 4.72%.
This calculation serves as a valuable tool to assess the profitability of your investment and make informed decisions about your real estate portfolio. Understanding this metric helps you assess whether this investment aligns with your financial goals.
2. The Capitalization Rate (CAP Rate)
The CAP rate calculation consists of the purchase price of the property and the net operating income. CAP rate is calculated as
Example 1- To Calculate CAP Rate
- Property worth = $10 million
- Generating net operating cost = $500,000
CAP Rate = (Net Operating Income / Purchase Price) * 100 = CAP%
CAP Rate = (500,000/ 10,000,000)*100 = 5%
Example 2- CAP Rate Formula To Estimate Property Value
Let’s say the net operating income of a property is $60,000 and it is expected to rise by 3% annually.
If the investor’s expected rate of return (ROI) is 10% per annum, then the net cap rate will come to (10% – 3%) = 7%. Putting it in the above formula, OperatingYour asset valuation will come to ($60,000 / 7%) = $8,57142.85.
3. The Cash-On-Cash Return
This cash-on-cash return formula considers the annual cash flow generated by the property and the total amount of cash invested. You can calculate cash-on-cash return as:
Suppose you are interested in purchasing a rental property as an investment. Here are the details of the investment:
- Purchase Price of the Property: $200,000
- Down Payment: $40,000 (20% of the purchase price)
- Closing Costs (including fees, taxes, etc.): $10,000
- Renovation Costs (if any): $5,000
- Annual Rental Income: $24,000
- Annual Operating Expenses (property taxes, insurance, etc.): $6,000
- Mortgage Loan Details: You took out a 30-year mortgage with a 4% interest rate, and your monthly mortgage payment is $763 (excluding taxes and insurance).
To calculate Cash-on-Cash Return (CoC), you first need to determine the annual cash flow and the initial cash invested:
Calculation of Annual Cash Flow:
- Annual Rental Income: $24,000
- Annual Operating Expenses: $6,000
- Annual Mortgage Payment (Principal and Interest only): $9,156 (12 * $763)
Annual Cash Flow = Rental Income – Operating Expenses – Mortgage Payment
Annual Cash Flow = $24,000 – $6,000 – $9,156 = $8,844
Calculation of Initial Cash Invested:
- Down Payment: $40,000
- Closing Costs: $10,000
- Renovation Costs: $5,000
Initial Cash Invested = Down Payment + Closing Costs + Renovation Costs
Initial Cash Invested = $40,000 + $10,000 + $5,000 = $55,000
Now, you can calculate the Cash-on-Cash Return (CoC):
CoC Return = (Annual Cash Flow / Initial Cash Invested) * 100
CoC Return = ($8,844 / $55,000) * 100 = 16.08%
Factors That Affect Real Estate Rental Property ROI
There are various factors that can affect the ROI of your rental property. Here’s the list of four factors that you must consider:
- Future Property Preference:
Future property preference is a must, as the increase in your property’s value over time can boost your ROI when you decide to sell it in the future.
- Home Financing Costs:
When buying an investment property on loan, your property’s mortgage and interest rate terms can affect your financing costs. This in turn impacts your overall ROI.
- Tax Implications:
Tax benefits and liabilities, such as capital gains taxes, and deductions can influence your rental property’s overall ROI.
- Property Condition and Age:
In the investment property game, buying a property is not enough to make it rented for a good amount. Many people look for a well-furnished and trendy home and generally look for a modernized property that comes in top condition. This makes a home’s age and conditions important factors that play into its value and overall success in the market.
Therefore, understanding these factors is crucial for making informed investment decisions.
Tips To Improve ROI Real Estate Rental Property
Here are some effective tips you can consider to improve your rental property ROI:
- Property Management Company
Hiring a property management company, or a property manager delivers you lot of benefits. This includes an increase in your annual income, better tenant management, on-time rental payments, etc.
- Choose the Right Location
Location is one of the major factors in real estate that can increase or decrease your ROI. Therefore, you must research the market thoroughly to identify areas with potential for property appreciation and have a strong rental demand.
- Setting Up Right Rent
Considering a fair or competitive rental amount is essential to attracting tenants and maximizing your rental income. Always make sure to conduct a market analysis to determine the fair rent for your property.
Balancing affordability with market rates is key to optimizing ROI on residential rental property.
- Make Use of Tax Benefits
Another way to improve your rental property ROI is to explore available deductions and credits for rental property owners.
Deductible expenses like mortgage interest, property taxes, and depreciation can reduce your tax liability, increasing your net income and ROI. You can even consult a tax professional for guidance.
- Minimizing Expenses
This point might sound so obvious, yet many property owners forget to do so. We suggest you keep your expenses in check by prioritizing regular maintenance. A well-maintained property reduces repair costs in the long run and attracts quality tenants. You can also consider energy-efficient upgrades to lower utility expenses.
By implementing these tips, you can enhance the return on your rental property investment and make the most of your real estate ventures.
Hidden Benefits of Owning Rental Property ROI
- Owning rental property will help you build wealth over time. Having rental property ROI isn’t just about instant profits, it’s a long-term wealth-building strategy.
- It will show diversification in your investment portfolio. It will display your profile beyond bonds and stocks, reducing risk and will enhance your financial stability.
- Having real estate rental property ROI will help you achieve financial independence, provide financial security, and allow you to pursue other life goals.
Common Mistakes to Avoid When You Calculate ROI on a Rental Property
- Neglecting Property Management: Poor property management can lead to high turnover, tenant issues, and decreased profitability. Therefore, effective management is crucial.
- Underestimating Expenses: Failing to account for all expenses, including maintenance and vacancies, can lead to financial stress and lower ROI.
- Ignoring Market Trends: Ignoring market trends can result in missed opportunities for property appreciation and maximizing rental income.
- Overlooking the Importance of Location: Location plays an essential role in ROI. Overlooking its significance can lead to poor rental demand and lower income potential.
In A Nutshell
The ROI for a rental property can differ from other investments. It differs, generally due to cash payments and financing. As a general rule of thumb: The less cash paid upfront = The larger the mortgage loan balance will be but will offer you greater ROI.
So, by getting a better command over landlord essentials, such as ROI calculations, factors, mistakes, and benefits. You can get a better grasp on expense tracking, accurate income, and detailed real estate analytics and maintenance management. Make sure to learn all the above essentials, and by taking rental property management, get ready to achieve heights and maximize your real estate rental property income.