Rental properties are a great way to make money and build wealth quickly. You’ll need to learn how to calculate your return on investment (ROI) as a landlord to determine your investment profit.
Every real estate investor knows how vital the return on investment is – the real estate investment metric used in comparing the performance of various investments or estimating and evaluating the performance of an investment.
Unfortunately, it’s often challenging figuring out the correct ROI calculation, seeing as some rental value calculators could be easily manipulated.
Additionally, real estate investors might take out a mortgage on the property or pay cash; therefore, some variables can either be excluded or included during the calculation.
If you’re a new real estate investor or an old hand still struggling with calculating your return on investment, you’ll find this post on calculating ROI on rental property quite helpful.
But before we delve into how to calculate your average ROI on a rental property, let’s understand its meaning first.
Meaning of Return on Investment (ROI)
Return on investment (ROI) measures the amount of profit or money your investment made as a percentage of the investment’s cost.
It indicates how efficiently and effectively investment dollars are used to generate profits. With the proper ROI knowledge, investors can assess and decide if investing in a specific property or location is a wise decision or not.
Calculating the average ROI is sometimes challenging since calculations are often easily manipulated, with certain variables sometimes missing in the analysis.
When an investor pays in cash or takes a mortgage on the property, it may affect the real estate investment calculation.
The Importance of ROI for Rental Property
Learning the ROI of any investment helps you become an informed investor.
Before investing in any real estate property, estimate your expenses and costs and also your rental income.
That way, you can compare it with other similar properties. After that, you can determine the amount to make from it.
Suppose you later realize that your expenses and costs will surpass your ROI; you can decide to sell to avoid losing out or ride it out and believe you’ll make a profit later after the storm has passed.
Rental Property ROI Calculation
Most if not all real estate investors are aware of the simple formula rental property calculator, which is:
ROI = (investment gain – investment cost)/ investment cost.
Let’s expand it further for the sake of newbie investors.
Suppose you invested $100,000 in an investment property, and the total profits you made from the investment is $140,000, then the ROI is:
($140,000 – $100,000)/$100,000, which is 0.4 = 40 percent.
As you can tell, I used the simple ROI formula, which is very general, with lots of unproven numbers and estimates.
However, you can determine the ROI of a rental property with the cash on cash return and cap rate formulas.
Choosing an ROI calculator depends on how you pay for the property.
This ROI calculation method is a bit complicated. Rental property investors adopt this calculation method when they take a loan or mortgage to pay for the rental property.
The formula for calculating the CoC is:
CoC = (annual cash flow/total cash invested) x 100 percent.
For example, suppose you buy a short-term rental property for $200,000 but took a mortgage and dropped a 20 percent down payment; your costs are:
$20,000 down payment ($200,000 buying price x 20 percent).
$2,500 for closing costs because of the mortgage.
$9,500 for remodeling the property; you don’t need to build a new house. You can renovate and remodel an existing one to avoid all the problems that comes with constructing a new building.
Therefore, your total invested cash is $32,000 ($20,000 + 2,500 + 9,500).
Don’t forget the monthly interest payment for the mortgage, which in this instance is $1000.
After renting out the property and your tenant pays $1500 every month, your cash flow will be $500 every month ($1500 rent – $1000 mortgage payment).
This result means that your net annual return or income is $6,000.
Now, use the CoC formula to divide the annual cash flow by the total invested cash to determine your return on investment (ROI).
Cash on Cash Return = (6,000/32,000) x 100 percent = 18.7 percent.
That’s your rental property’s return on investment.
Cap Rate Calculation
Real estate investors use the cap rate to calculate the average ROI on the rental property when they pay fully with cash.
While cap rates are used to measure an investment property’s profitability, it’s more generally used to compare related real estate investments.
Cap rate defines the ratio between a rental property’s purchase and its net operating income. Therefore, NOI = rental income – operating expenses.
The cap rate calculation formula is:
Cap Rate = NOI/Purchase Price x 100 percent
The cap rate calculation is quite simple. For instance, you bought a rental property and paid $200,000 in cash, $2,000 in closing costs, and $9,500 for remodeling.
This result means that your total investment in the rental property is $215,000.
Suppose your tenant pays $1600 for rent every month, meaning you get $19,200 yearly.
For a more realistic ROI, let’s deduct $2,000 from the cash flow each year to cover other unavoidable expenses like property insurance, property management, maintenance, and property taxes.
Thus, your annual return will be $14,600.
To calculate your rental property’s ROI, follow the former cap rate formula and divide the annual return ($14,600) by the total investment you made before ($215,000).
Cap Rate = ($14,600/$215,000) x 100 percent = 6.7 percent.
This result means that your ROI is 6.7 percent.
The Bottom Line
As a landlord, you need to know the various methods of calculating the average ROI of your rental property.
Depending on the manner of your rental property purchase, either taking a mortgage, dropping a downpayment, or paying fully in cash, you can calculate the ROI using the cash on cash return or cap rate.
You can also calculate the ROI using the simple formula. Consider other metrics like the positive/negative cash flow and potential rental income while calculating your rental property’s return on investment.
You might want to contact experts at The Short Term Shop to help guide you through the entire ROI calculation process till you become a pro at it.