How To Calculate ROI For Your Rental Property?

Whether driven by long-term retirement goals, saving for significant life events such as starting a family or planning a dream wedding, or simply aiming to generate additional income, the underlying motive for investing remains the same: financial growth. 

When it comes to real estate there are a few ways this wealth growth can play out over the long term. For example, if you invest in residential rentals you might set specific goals for appreciation, equity growth, and cash flow. Alternatively, you might look at shorter-term gains with a different investment strategy like BRRRR or fix and flips.

Regardless of the investment strategy you choose, astute real estate investors will evaluate the property's profitability through the lens of Return on Investment (ROI). Understanding the concept of ROI, mastering its calculation specific to rental properties, and recognizing its significance, is foundational for making informed decisions when investing in real estate. 

In this comprehensive guide, we delve into how to calculate ROI on rental property, unveiling its potential to unlock real estate investment success.

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Key Takeaways

• ROI, or Return on Investment, quantifies the profitability of an investment by determining the percentage of profit or income generated relative to the initial investment cost.
• For cash purchases, calculating the percentage ROI involves dividing the net profit or gain obtained from the investment by the original cost.
• When considering properties with a mortgage, it becomes crucial to incorporate factors such as the down payment and mortgage payments into the ROI calculation.
• Several variables influence how to calculate ROI on rental property, including expenses associated with repairs, maintenance, and routine costs, all of which must be considered in the overall assessment.

What Is Return On Investment (ROI) On A Rental Property?

Return on Investment (ROI) is a metric used when calculating the profitability of an investment. It gives an indication of how effective leverage is, and to what extent invested funds translate into monetary gains. 

Whether investing in stocks, bonds, savings accounts, or real estate properties, ROI provides a standardized measure to assess the viability of allocating funds to a specific investment. In the realm of real estate, where diverse investment avenues exist, understanding and calculating ROI becomes central for informed decision-making. 

However, determining a meaningful and useful ROI for investment properties, particularly rental properties, can pose challenges due to the number of variables that impact the calculation. For example, whether you make a cash purchase or finance the property through a mortgage, the ongoing operating costs and expected cash flow, and any potential renovations.

How To Calculate ROI On A Rental Property?

Calculating the return on investment (ROI) for your rental property can be done using several different methods:

• the simple ROI calculation,
• the capitalization rate (cap rate),
• and the cash-on-cash return.

The method you choose will depend on factors that we've already mentioned, such as the loan amount and the financing method used to purchase the property.

Calculating ROI for rental properties is normally done by subtracting the total operating costs from the total rental income for the year and dividing this number by the mortgage value (or the remaining loan amount).

The formula for this calculation is as follows:

ROI = (Annual Rental Income - Annual Operating Costs) / Mortgage Value

This straightforward calculation provides an estimate of your investment gains or losses.

Alternatively, you can use the cap rate method. This is calculated using the following formula:

Cap Rate = Net Operating Income / Purchase Price × 100%

The cap rate takes into account the net operating income and the purchase price of the property.

A third method for calculating ROI is by measuring the cash-on-cash return, which is calculated as:

Cash-on-Cash Return = (Annual Cash Flow / Total Cash Invested) × 100%

This cash-on-cash formula considers the annual cash flow generated by the property and the total amount of cash invested.

It's important to determine which method makes the most sense for your rental property. If you prefer to use a financial calculator, you can utilize tools like the Landlord Studio rental yield calculator. 

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What Is A Good Rate Of Return On A Rental Property?

A good rate of return on your real estate investments will vary widely depending on a variety of factors. This includes the property price, how much cash you invest, how much rent you charge, where you invest, local fees such as property taxes, property management fees, and mortgage interest.  

Ultimately then, determining a “good” ROI is entirely dependent on your rental business structure and goals. However, with all that being said, as a ballpark figure many investors aim for an ROI between 8 to 12%.

Example: Calculating ROI on Rental Properties

While the equations provided above may appear straightforward, it is important to remember how the variables in real estate can impact ROI calculations. Factors such as repair and maintenance expenses, as well as your financing and leverage, can influence ROI figures. To illustrate, let's examine two examples of calculating ROI for a rental property.

ROI for Cash Transactions

Calculating a property's ROI is fairly straightforward if you buy a property with cash as there are fewer variables to account for. Here's an example of a rental property purchased with cash:

• You paid $125,000 in cash for the rental property.
• The closing costs were $1,250, and remodeling costs totaled $11,250, bringing your total investment to $137,500 for the property.
• You then collect $1,250 in rent every month.

A year later:

• You earned $15,000 in rental income for those 12 months.
• Recurring expenses, including the water bill, property taxes, and insurance, totaled $3,600 for the year or $300 per month.
• Your annual return was $11,400 ($15,000 - $3,600).

To calculate the property’s ROI:

• Divide the annual return ($11,400) by the amount of the total investment, or $137,500.
• ROI = $11,400 ÷ $137,500 = 0.083 or 8.3%.

Your ROI in this scenario would be 8.3%.

ROI for Financed Transactions

Calculating the ROI on financed transactions involves more details. Let's consider an example using the same $125,000 rental property as before, but this time with a mortgage:

• Purchase price: $125,000
• Downpayment: 20% of the purchase price, amounting to $25,000
• Closing costs: $3,000 (higher due to the mortgage)
• Remodeling expenses: $11,250
• Total out-of-pocket expenses: $39,250 ($25,000 + $3,000 + $11,250)

Considering the ongoing costs of the mortgage:

• Loan details: 30-year term with a fixed 4% interest rate
• Monthly principal and interest payment: $477.42 on the borrowed $100,000
• Additional costs: $300 per month for water, taxes, and insurance
• Total monthly payment: $777.42

Rental income:

• Monthly rental income: $1,250
• Total rental income for the year: $15,000

Cash flow:

• Monthly cash flow: $472.58 ($1,250 - $777.42)

After one year:

• Total rental income for the year: $15,000
• Annual return: $5,670.96 ($472.58 x 12 months)

To calculate the property's ROI:

• Divide the annual return by your original out-of-pocket expenses: $5,670.96 ÷ $39,250
• ROI = 0.144 or 14.6%

Your ROI in this scenario would be 14.6%.

So, while your cashflow is much lower, your ROI is actually higher because of your ability to leverage - you're getting more bang for your buck.

Use our free mortgage calculator

Home Equity 

Some investors choose to factor in the home's equity when calculating ROI. Equity represents the market value of the property minus the remaining loan amount. It's important to note that equity is not cash-in-hand and can only be accessed by selling the property.

To determine the equity in your home, you can review the mortgage amortization schedule, which outlines the portion of your mortgage payments dedicated to reducing the loan's principal. This contributes to the growth of equity in your property.

In our example, the amortization schedule reveals that $3,300 of principal was paid down during the first 12 months.

When including the equity portion, the new annual return amounts to $8,970 ($5,670.96 annual return + $3,300 equity).

To calculate the property's ROI:

• Divide the new annual return by your total out-of-pocket expenses: $8,970 ÷ $38,750
• ROI = 0.231 or 23.1%

Therefore, your ROI would be up to 23.1%.

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The Importance of ROI for Real Estate

Understanding the how to calculate ROI (Return on Investment) is crucial for real estate investments as it enables informed decision-making. Before making a purchase, it is essential to estimate the costs, expenses, and potential rental income associated with the property. This allows for meaningful comparisons with other similar properties.

If, at any point, it becomes evident that costs and expenses will exceed expectations (meaning you can't achieve your target ROI), one must carefully consider whether to continue holding the property in hopes of future profits, or opt to sell and minimize potential losses.

It’s also important to account for possible vacancies during periods when the property is not rented out and additional unexpected expenses related to owning a rental property, such as repairs or maintenance costs. These factors need to be included in your calculations, as they can significantly impact the overall ROI.

Real estate investors can also explore diversifying their portfolios while maintaining their ROI through pooled investments such as real estate investment trusts (REITs). These investment vehicles allow for broader exposure to the real estate market and can provide a consistent return on investment.

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Manage Your Rental With Landlord Studio

The goal of managing rentals is to build wealth. This is why it’s so important to stay on top of your finances, to know your figures, and to accurately calculate key ketrics like ROI for your property.

Landlord Studio is the #1 property management and accounting software that gives you all the tools you need to accurately track your finances throughout the year. You can instantly generate any of over 15 accountant-approved reports for nuanced financial detail, and gain quick insights into your portfolio performance through the dashboard.

With accurate and up to date data you can ensure you've got all the numbers you need to maximize your profits and minimize your tax liabilities.

Create a free account today and to collect rental fees, streamline rental property accounting, track maintenance requests, run financial reports, and more — all in one place. 

Calculating ROI: The Bottom Line

When it comes to ROI, rental properties differ from other investments due to factors like financing and cash payments. Generally, a smaller upfront cash payment with a larger mortgage loan balance can result in a higher ROI, while a larger upfront cash payment with less borrowing leads to a lower ROI. Financing can provide a short-term boost to ROI by reducing initial costs - however, it reduces cash flow.

To obtain an accurate view of your investment portfolio, it's important to adopt a consistent approach when measuring ROI for multiple properties. For instance, if you include the home's equity in evaluating one property, you should consider the equity of other properties when calculating the ROI for your real estate portfolio. This holistic approach ensures a comprehensive understanding of your investment performance.

Finally, by leveraging software like Landlord Studio you gain a range of valuable tools including income and expense tracking, receipts scanner, bank reconciliation, and detailed real estate reporting and analytics which will prove crucial when it comes to optimizing your portfolio profitability.

Start using Landlord Studio today to take control of your rental business and maximize your ROI.

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