When considering a rental property, one of your key concerns should be whether it will yield a return on investment (ROI) that makes sense financially. This is why calculating your ROI is essential when evaluating a deal, or, if you already own a rental, it’s a great way to do a quick profitability check. With that in mind, you’ll want to become familiar with the tools used for calculating rental property ROI, which includes formulas for those who like to do the math themselves, as well as simple online calculators.
Understanding Return on Investment (ROI)
I’ve learned through experience that a rental property should never be purchased without first calculating the return on investment to determine if it will be a profitable deal or not. After all, making a profit is the end goal, right? That said, ROI is an important metric because it measures the percentage of return generated relative to the money an investor puts into the property – you never want to dish out more than you can reel in; this will put you in the red.
As a quick explanation, calculating ROI involves dividing the annual net income the rental generates by the total investment cost. To find the annual net income, you’ll utilize such expenses as maintenance repairs, property taxes, to name a few, as well as the rental income potential. Additionally, examples of typical investment costs include the purchase price, closing costs, and any renovations or improvements. In the end, it’s essential for investors to crunch the ROI numbers before considering buying a rental property because a high ROI translates into a more lucrative investment.
Ok, now that you have a general understanding of how important the return on investment metric really is, you’ll want to have the tools for calculating ROI, and I’ll cover that below.
Calculating ROI for Real Estate Investments
Calculating your ROI can be pretty simple, but it all really depends on how much financial information you want included in your assessment. I’ll begin with the basic calculation and then jump into an alternative formula you’ll want to become familiar with. But before we move on, here’s a related article you can bookmark for future reading – ROI Calculator for Real Estate: Calculation, Interpretation, and Decision-Making.
1. Start with a Simple ROI Formula
If you’re new to the game, it’s always a good idea to start with the basic formula, which is:
Annual Net Income / Total Investment × 100 = ROI (%)
The formula is pretty self-explanatory. First, you’ll need to come up with your annual net income. To do this, you use the following formula: Annual Net Income = Annual Rental Income – Annual Expenses, in which you take your projected income (rental income) and subtract the projected annual operating expenses. These expenses typically include mortgage payments, repairs, property management fees, property taxes, landlord insurance, and more, depending on your circumstances. Let’s break this down a bit with an example so it’s more clear:
If a property brings in $30,000 in rental income a year and has a total of $10,000 in annual operating expenses, you would input the numbers as follows:
Annual Rental Income ($30,000) – Annual Expenses ($10,000) = Annual Net Income ($20,000)
Now that you have the first metric in hand, which is annual net income of $20,000, you’ll now need to calculate the second part, which is the total investment. This is done by simply adding up the property purchase price and the closing costs, along with any renovations. To generate a number for our example, let’s say the purchase price is $250,000 with closing costs of $12,000, and $0 in renovations, you’ll come to a total investment of $262,000.
Now you have all the elements needed to complete the basic ROI formula:
Annual Net Income ($20,000) / Total Investment ($262,000) × 100 = ROI (7.63%)
Your final rental property ROI comes to 7.63%, which is considered good because most investors shoot for a percentage between 8-6%. However, ROI metrics are just a starting point when it comes to determining if a property is worth considering or not. There’s a lot more to look into, such as where the housing market is headed, if the crime rate is on the rise or not, the vacancy rate of the neighborhood, and if the local economy is on the cusp of declining or thriving, and so on.
Let’s move on and cover an alternate ROI calculation metric.
2. Using Capitalization Rate for Return on Investment Estimates
The basic ROI formula and cap rate metrics are both used to assess real estate profitability. However, they each measure different aspects of the investment. For instance, the cap rate measures the income-generating potential of a rental property, while a basic ROI calculation focuses on the total profit earned relative to the total investment.
As for the cap rate, it represents the rate of return on a piece of real estate based on the amount of income it generates prior to factoring in financing. Another way to phrase this is that it enables an investor to calculate the amount of net income a rental property earns compared to its market value. The whole purpose of the cap rate metric is to make sure a property purchase won’t end up in a financial loss. That said, let’s find out how to determine the rate of return on a rental using cap rate metrics:
Cap Rate Formula:
Below is the standard formula for generating a property’s cap rate.
Net Operating Income / Property Value x 100 = Cap Rate
To use the cap rate formula, you have to begin by determining a few of the needed components first, starting with the net operating income (NOI). The NOI is the rental income with operating expenses subtracted. The expenses would be the same as what’s needed in the basic ROI formula that we discussed, which would be items such as property management, repairs, insurance, and so on. Once you have the total NOI (income minus expenses), you divide that number by the property purchase price. You then take that number and multiply it by 100 to get a percentage. This may all sound a bit confusing, so I’ll provide an example with actual numbers for determining the NOI:
An investor is considering a rental property that will generate $30,000 in rental income and has operating expenses of $7,000.
$30,000 (rental income) – $7,000 (operating expenses) = $23,000 (NOI)
Now with the NOI in hand, you simply input that number, along with the property’s purchase price/value into the cap rate formula. For this example, we’ll put the property value at $360,000:
$23,000 (NOI) / $360,000 (Property Price) x 100 = 6.3% (Cap Rate)
The final cap rate comes to 6.3%, and this is considered a good figure as most investors look for a number between 5-10% when comparing similar properties in the area.
Using an Online ROI Calculator
If you’re not interested in spending time crunching numbers, or you’re a beginner and need help, there are some online ROI calculators you can turn to. This comes in handy if you’d like to quickly evaluate properties with fast calculations. These return on investment tools are designed to enable an investor to input all the essentials.
Here are a few online ROI calculators that will help you input your numbers to determine if a property is worth looking into further:
Strategies for Maximizing ROI
Since you’re seeking out information on how to calculate ROI, then it would be wise to research how to maximize your return on investment. There are many strategies for improving rental income and property value to increase your ROI, but here are a few that successful investors focus on:
Strategies for Maximizing ROI
Since you’re seeking out information on how to calculate ROI, then it would be wise to research how to maximize your return on investment. There are many strategies for improving rental income and property value to increase your ROI, but here are a few that successful investors focus on:
1. Tenant Screening:
One of the most important things you can do to protect your return on investment is to properly screen potential tenants. Why? Because one bad tenant could end up costing you thousands of dollars. Read this post that covers screening renters for insider tips – How to Screen Tenants to Keep Your ROI on Track.
2. Rental Inspections:
Doing routine property inspections is crucial to keeping your rental in tip-top shape. It allows you to maintain and fix issues before they get out of hand from going unnoticed for too long. This, in turn, enables the landlord to charge the maximum rent and also keep the property value on an upward trend. Head over to my post on inspections for some helpful tips – Streamlining Rental Property Inspections by Creating Checklists.
3. Property Managers:
Seasoned investors utilize property managers to maintain their rentals because they know it keeps ROI on track. Find out why this is the case in my write-up on the topic – Property Management Fees and Why They’re Worth the Cost.
4. Rent Guarantee Insurance:
Having rent insurance in place can keep your ROI on track if a tenant is unable to pay and you can’t recoup that money. Dive into my article for more details on Exploring Rent Guarantee Insurance.
5. Landlord Insurance:
Having this type of insurance in place protects your ROI because it covers unexpected issues that could otherwise cost you thousands out of your own pocket. Here’s a post on the topic – Understanding Landlord Insurance Coverage.
6. Full-Service Rental Real Estate Company:
Obtaining your rental property through a full-service company will ensure everything is lined up from the start to achieve a high return on investment.
You can read more about these strategies, as well as additional details by diving into my article on the topic – Maximize Cash Flow by Investing in Rental Properties that Deliver
Another strategy for maximizing ROI is to learn as much as you can and stay on top of your game. With that in mind, below, you’ll find a few of our power resources that can help you achieve this:
Incorporate ROI Calculations into Your Real Estate Game Plan
Those who have been around the rental real estate block a few times know that going into a deal blindly could be a costly mistake. That’s why doing your due diligence by crunching the numbers ahead of time and calculating ROI or other metrics is imperative. There’s really no excuse not to dive into metrics such as these when considering a property since the formulas are pretty simple. On top of this, online tools for calculating rental property ROI make it even easier.
As mentioned, working with a full-service company such as Morris Invest can help keep your return on investment in line – we run all the metrics for you. Our new construction properties have been proven to be lucrative, cash flowing investments that can set you on the path to financial independence. Feel free to schedule a complimentary call if you have any questions or would like to hear about our properties, where they’re located, what their potential returns are, and so on. We’re here to make it simple for you to get set up with a high-performing rental property, so don’t hesitate to reach out.
Before you go, dive into the following video I put together that details ROI and IRR metrics:
