Making money in real estate is the main purpose of any investment property. Because such profit is important, investors need to use thorough and helpful metrics to measure profitability. The best metric for this job is return on investment on rental property. But just what is return on investment, and what is a good annual return on investment?
What Is Return on Investment on Rental Property?
Return on investment, or ROI for short, is the baseline metric used to evaluate the returns of an investment property. The return on investment on rental property tells investors how profitable the property is as a percentage. ROI uses cash flow and property price in its calculation like so:
ROI = [(Annual Rental Income – Annual Rental Expenses) ÷ Total Cash Investment] × 100%
Annual return on investment, also known as rate of return, depends on three factors. All of these factors are areas of focus when buying an income property. The first factor is the annual rental income. This is simply estimated by multiplying the weekly income by 52 or the estimated monthly income by 12. The sum of rental expenses is the second variable in play. These may include operating costs but not investment property financing costs. Lastly, total cash investment refers to a property’s listing price, fair market value, or total cash invested to acquire the property, depending on the scenario.
What Are Cap Rate and Cash on Cash Return?
You might hear terms such as cap rate and cash on cash return as being synonymous with the annual return on investment. While they are not exactly the same as ROI, cash on cash return and cap rate act as modified equations of the original ROI.
The annual return on investment (ROI) is a great standard for measuring property performance and estimated performance, but it is not the best metric for comparison. The reason is that ROI does not consider any potential investment property financing costs. Cap rate, however, does just that. Here’s how cap rate, or capitalization rate, is calculated:
Cap Rate = (Net Operating Income ÷ Property Price or Fair Market Value) × 100%
The variables of this return on investment on rental property metric are net operating income and property price. Net operating income, or NOI, is the difference between rental income and operating expenses of an investment property. Operating expenses include rental expenses and potential investment property financing fees, which makes cap rate a useful metric for comparison when buying an income property. Despite this, cap rate does not differentiate between financing methods. It merely takes them into account, which the standard ROI does not. The second variable is the fair market value or FMV. This is the value of a property, which can be the same as its property price.
Cash on Cash Return
Cap rate is best utilized for property comparison, but not actual property performance. The standard return on investment on rental property metric is actually more useful than cap rate in this regard, but there is a more precise measurement you can use. That metric is cash on cash return or CoC. Cash on cash return presents how an investor is making money in real estate by replacing property price with the total amount of cash invested:
CoC = (Before-Tax Cash Flow ÷ Total Cash Invested) × 100%
By measuring the total amount of cash invested, the CoC calculates a property’s profitability in any particular moment. The total cash invested is the sum of purchasing and financing payments, which range from closing costs to mortgage payments. Cash on cash return also uses before-tax cash flow or BTCF. BTCF is the difference between net operating income (NOI) and debt service, which includes mortgage-associated fees.
Calculating Annual Return on Investment: Examples
Now that we’ve covered how to calculate each annual return on investment metric, let’s calculate the ROIs of some examples. Keep in mind that, normally, you would use an ROI calculator, or investment property calculator, to conduct a return on investment analysis, which is part of the greater investment property analysis. This is particularly helpful when searching for and analyzing multiple properties.
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A $425,000 multifamily investment property generates $1,200 from its 3 units monthly, and its total rental expenses are $208 during that time period. What is its annual return on investment?
ROI = [($1,200 × 3 units × 12 months) – ($208 × 12 months) ÷ $425,000] × 100 = 9.57%
Cap Rate Example
An investment property analysis computes that the annual NOI of the same property is $34,704. What is the property’s return on investment on rental property as cap rate?
Cap Rate = ($34,704 ÷ $425,000) × 100% = 8.16%
An investor purchases the same multifamily property. After a few years of investing a total of $300,000 in the property, the investor computes the BTCF to be $30,000. What is the return on investment on rental property as cash on cash return?
CoC = ($30,000 ÷ $300,000) × 100% = 10%
What Is a Good Annual Return on Investment?
So, which of the three previous annual return on investment percentages is considered good? Also, what is a good ROI? Generally speaking, a good return on investment on rental property ranges from 8 to 12%. The higher the annual return on investment, the better and more profitable the property is. These standards apply to all three types of annual return on investment.
The percentage range is a good standard to follow. However, it is not the main parameter to consider. The range for what is a good ROI will differ based on location. The best real estate investments in an affordable area, for instance, tend to have higher ROIs than those in expensive markets. What matters the most is that the investor understands the good ROI range in his/her location. At the end of the day, real estate is all about location.
How to Find Investment Properties with a High Return on Investment on Rental Property
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