To calculate the return on investment in real estate is a prerequisite to guarantee profitable investments with positive cash flow returns.
Crunching the numbers before purchasing rental property is not a choice if you want to safeguard a profitable real estate business with long-term financial rewards.
Conducting the right due diligence and performing real estate market analysis allows real estate investors to capitalize on real estate opportunities yielding strong returns and bigger rewards. So, before you go for buying your first rental property, make sure to assess and estimate the profit quota on an investment discounting all the expenses and carrying costs. To do this, we shed light on the most important return on investment formula used in real estate investing.
Related: How residential real estate investing will secure your financial independence
Top Return on Investment Formula in Real Estate Investing
1. Return on Investment (ROI)
The first go-to formula in real estate is the ROI which takes into account the gross rental income and expenses of a rental property.
To calculate ROI on a rental property:
ROI = (Annual Rental Income – Costs and Expenses)/Cost of Property
- Calculate annual rental income.
- Aggregate the costs and expenses associated with the rental property. These include your closing (paid only once) and carrying costs (costs associated with running the rental property).
- The cost of the property is the fair market value.
Keep in mind that the ROI is a very simple return on investment formula which doesn’t take into account whether the property is fully paid in cash or financed via a mortgage loan.
To delve deeper, there are two ROI formulas you can use to further assess the profitability of a rental property.
a) The Cost Method Return on Investment Formula
The cost method return on investment formula calculates the equity/value of rental property to its total cost. For example, let’s say you buy a rental property for $150,000, and you pay an extra $50,000 on repairs. Now, the rental property is valued at $250,000, which puts your ROI at $50,000 ($250,000 – $200,000), or 25% return ($50,000/$200,000).
b) Out of Pocket Return on Investment Formula
To elaborate on the previous example, the out of pocket return on investment formula reaps a higher ROI because it takes into account the down payment. So, if the rental property is financed with a down payment of $20,000 and an extra $50,000 on repair, your out of pocket expense becomes $70,000, which gives you a total equity of $180,000 with a total ROI of 72%.
2. Capitalization Rate (Cap Rate)
Another return on investment formula in real estate investing is the cap rate, which calculates the profitability of an investment from the net operating income, without taking into account how the investment property is financed.
Mathematical Formula:
Cap Rate (%) = (Net Operating Income/Current Market Value) x 100
Net Operating Income (NOI) = Annual Rental Income – Operating Expenses
Current Market Value (MV) = Price of Property
Let’s suppose that an investment property costs $1,000,000, and its NOI is $100,000. The cap rate for this investment property would be: $100,000/$1,000,000 = 10%.
10% is considered a good cap rate and a good benchmark. For real estate comps, Mashvisor shows the cap rates for all rental properties (traditional and Airbnb) across the country in an instant. You don’t even have to do any manual work! However, cap rates are relative and should be compared with other cap rates in order to find the best real estate investment for you. While a cap rate of 10% can be excellent for a certain location, it might be pretty low for another location.
3. Cash on Cash Return (CoC)
This return on investment formula estimates the cash returns on an investment. For real estate investors capitalizing on positive cash flow properties, the cash on cash return on investment formula is essential. It simply tells you how much cash you will make compared to how much cash you have spent on your rental property.
Cash on Cash Return on investment formula = Net Operating Income/Total Cash Investment
To maximize your rental property CoC return:
- Capitalize on the right location.
- Perform investment property analysis.
With the right location, landlords/real estate investors achieve high rental demand and rental income to safeguard a positive cash flow property in the long term. But before picking the right location for your real estate investment, make sure to conduct investment property analysis to assess and calculate the profitability of the rental property in the long run. To sum it up for you, investing in the right property and in the right location yields the strongest returns in real estate.
Related: Top Performing Cash on Cash Return Neighborhoods in Pittsburgh
4. Mashvisor’s Investment Property Calculator: The Most Important Return on Investment Formula
To put it all together, Mashvisor’s investment property calculator helps real estate investors and real estate agents calculate the ROI on a rental property in an instant. Without the need to do any manual work, the investment property calculator is essentially the most important return on investment formula because it combines all of the formulas in one.
In addition to calculating the cash on cash return, the cap rate, and the cash flow returns, Mashvisor’s investment property calculator gives real estate investors a deeper insight on the profitability of a rental property via:
- Mashvisor’s heatmap tool: This shows which areas in a specific state, city, or neighborhood are the best options for real estate investing.
- Mashvisor’s Mashmeter: This shows a success score of a real estate investment based on qualitative and quantitative data collected from Mashvisor’s traditional and predictive analytics.
Related: The Best Investment Advice to Make Money in Real Estate
Conclusion
To measure the true profitability of any real estate investment, investors must perform the right real estate market analysis and use the appropriate return on investment formula to conduce to success. Real estate investing is only worthwhile if investors spend time to learn and acquire real estate knowledge to become their own expert.
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