Calculating ROI On A Rental Property
Real estate refers to tangible property made up of land and includes structures or other resources. Investment properties are one example of real estate investment. Many people purchase investment properties in the hope of renting out their income. Many people purchase investment properties intending to sell them in the future.
It doesn't matter what the investor's intention is. It's crucial to calculate the return of investment (ROI). This will help determine a property's profitability. Let's take a look at ROI and how to calculate it for rental properties. This will help you understand why you should know the ROI of a property before you buy it.
What Is Return On Investment?
As a percentage of investment cost, the return on investment (or profit ) measures the generated money or income. It shows how efficiently and effectively investment dollars are being used in order to generate profit. Investors can use ROI to determine whether investing in a specific investment is wise.
Any investment can use ROI, including stocks, bonds, savings accounts, and real estate. It can be difficult to calculate a meaningful ROI for residential properties. Calculations can be easily modified, so certain variables can be added or removed from the calculation. This can be especially challenging when investors choose either to pay cash or take out a mortgage.
We'll be looking at two options for calculating the ROI on residential rental properties: a cash purchase or one that is financed by a mortgage.
The Formula For ROI
Calculating the profit or loss on an investment is as simple as taking the total return and subtracting the initial cost.
To calculate the percentage ROI, we divide the net profit (or net gain) by the original cost.
Calculating The ROI Of Rental Properties
Although the above equation may seem straightforward, many variables affect real estate's ROI. These variables include repair and maintenance costs and methods of figuring leveraging--the amount borrowed with interest to make an initial investment. In addition, the overall investment cost can be greatly affected by financing terms.
ROI For Cash Transactions
If you purchase a property with cash, it is easy to calculate its return on investment. Here's an example of a rental property that was purchased with cash.
The cash payment was $100,000 for the rental property.
The closing costs were $1000, and the remodeling costs totaled $9,000, making your total investment in the property $110,000
Each month, you receive $1,000 in rent.
One Year Later:
For those 12 months, you earned $12,000 in rental income.
The total cost of expenses for the year included the water bill, real property taxes, and insurance. Or $200 per month.
Your annual return was $9,000. (between $12,000 and $2,400).
To calculate the ROI of a property:
Divide the annual return (roughly $9,600) by your total investment to get $110,000.
ROI = $9,600 / $110,000 = 0.0887 or 8.7%.
Your ROI was 8.7%.
ROI For Financed Transactions
It is much more complicated to calculate the ROI of financed transactions.
Let's say you buy the $100,000 rental property above, but you don't want to pay cash. So instead, you take out a mortgage.
The downpayment required for a mortgage was 20% of the purchase price or $20,000 (100,000 sales price x 20).
Closing costs were more than usual for mortgages and totaled $2,500 upfront.
Remodeling cost $9,000
Your total out of pocket expenses were $31,500 (20,000 + $2,500 + $9,000).
A Mortgage Has Ongoing Costs:
Let's say you take out a 30-year loan at a fixed 4% rate. The monthly principal and interest payments would be $381.93 for a loan of $80,000.
To cover water, taxes, and insurance, we'll add $200 each month, making your monthly payment $581.93.
Rent income of $1,000 per month equals $12,000 for the entire year.
Monthly cash flow $418.07 (1,00 rent - 581.93 mortgage payment).
One Year Later:
At $1,000 per month, you earned $12,000 in rental income.
Your annual return was $5,016.84 (418.07 x 12).
To Calculate The ROI Of A Property:
Divide your annual return by the original out-of-pocket expenses (the downpayment at $20,000, closing costs at $2,500, and remodeling at $9,000) to calculate ROI.
ROI = $5,016.84/$31,500 = 0.159
Your ROI is 15.9%
Home Equity
Some investors also add equity to the equation. Equity is the difference between the total amount owed and the property's market value. Home equity does not equal cash in hand. To access your home equity, you would have to sell the property.
For an estimate of your equity, look at your mortgage amortization to see how much of your mortgage payments were used for principal repayments. This increases your equity.
You can add the equity amount to your annual return. The amortization schedule showed that $1,408.84 principal was paid off in the first twelve months.
The new annual return includes the equity portion equals $6,425.68 ($5,016.84 annually income + $1,408.84 equity).
ROI = $6,425.68 / 31,000 = 0.20
Your ROI is 20%
Real Estate ROI: The Importance Of It
You can be a better investor by knowing the ROI of any investment. Estimate your expenses and rental income before you purchase. You can then compare the property to similar properties.
Once you have narrowed down your options, you can determine how much money you will make. If you find that your expenses and costs exceed your ROI, it's time to decide if you want to continue riding the wave and hoping to make a profit or sell to avoid losing out.
Additional Considerations
There may be additional costs involved in renting a property. These would need to be added to the calculations. This will ultimately impact the ROI.
We assumed that the property had been rented for 12 months. Vacancies can occur in many cases, especially when switching between tenants. You must include this in your calculations.
The Summary
A rental property's ROI is different from other investments. It will vary depending on whether it is mortgage-financed or cash-financed. The general rule of thumb is that the more cash you pay upfront to finance the property's mortgage loan, the higher your ROI.
However, the higher your initial costs and cash upfront, the lower your ROI. Because your initial costs are lower, financing can help you boost your ROI quickly.
When calculating the ROI of multiple properties, it is important to follow a consistent approach. For example, if you evaluate a property's equity, it is important to include equity from other properties in order to calculate the ROI for your real estate portfolio. This will give you the best view possible of your investment portfolio.
