What is Return on Investment?
Before we get into details about the average return on investment, we need to properly define what ROI is. Return on investment is essentially a real estate metric that quantifies many variables associated with an investment property’s profitability, such as rental income and rental expenses. This definition is broad, which allows for a broad formula to calculate return on investment:
ROI = (Annual Rental Income – Annual Rental Expenses) ÷ Property Price
Here’s a quick example to help you understand how to calculate return on investment. If a $325,000 single-family home generates $3,500 in monthly rental income and $2,000 in annual rental expenses, what is its ROI?
ROI = ($3,500 x 12 months – $2,000) ÷ $325,000 = 0.123 = 12.3%
Good Return on Investment
So, is the ROI in the example considered a good return on investment? The answer is yes! While the range of good return on investment differs from area to area based on various factors, anything above 6 to 8% can be considered good. Real estate investors need to find out what is considered good in their respective locations to have a clearer understanding of their return on investment property.
ROI is a powerful metric, even in its most general form. However, there are two derivations of ROI, called cash on cash return and cap rate, that prove to be very beneficial to real estate investors. We’ll begin discussing their differences right now, but for a detailed compare and contrast, read this blog: “Cap Rate vs. Cash on Cash Return“!
What is Cash on Cash Return?
Cash on cash return (CoC) is a modified version of the return on investment formula. It replaces property price with the total amount of cash invested in a property. Cash on cash return also differs from the general return on investment formula by using annual pre-tax cash flow instead of the difference between rental income and expenses.
CoC = Annual Pre-tax Cash Flow ÷ Total Cash Invested
If a property costs $325,000 but has only $125,000 invested in it and generates $20,000 in cash flow, what is its CoC?
CoC = $20,000 ÷ $125,000 = 0.16 = 16%
Cash flow does not depend on the price of a return on investment property. It only focuses on the amount actually invested in the property at a point in time. This allows the metric to be very accurate for real estate investors when determining the returns of a property during that point in time.
Good Cash on Cash Return
Like a good return on investment, a good cash on cash return differs by location factors. Generally, the range is from 6 to 12%. To learn more about what is a good cash on cash return, read this: “What is a Good Cash on Cash Return?”!
What is Cap Rate?
The other form to calculate return on investment is through the capitalization rate or cap rate. While CoC considers the method of financing when computing returns (by using the amount invested), cap rate calculates ROI regardless of the method of financing. This makes cap rate especially useful when comparing rental properties for purchase. The cap rate of a return on investment property is calculated as follows:
Cap Rate = NOI ÷ FMV or Property Price
NOI, or net operating income, is the difference between rental income and expenses of a property. FMV stands for the fair market value of a property.
Cap Rate Example
Calculating cap rate is relatively simple. Here’s an example: a $325,000 property has an NOI of $40,000. What is its cap rate?
Cap Rate = $40,000 / $325,000 = 0.123 = 12.3%
Good Capitalization Rate
Like CoC and ROI, the range of good cap rate differs from location to location. The general range is 6 to 12%.
What is the Average Return on Investment in the US Real Estate Market?
Now that we’ve covered the different forms of ROI we can finally answer the question: what is the average return on investment in the US? According to the S&P 500 Index, the average return on investment in the US real estate market is 8.6%. The average return on investment differs based on property investment strategies. Residential real estate has an average ROI of 10.6%, commercial real estate has an average return on investment of 9.5%, and REITs have an average return of 11.8%.
Is the Average Return on Investment Very Helpful?
It is definitely helpful to know the average ROI across the nation for comparison of your return on investment property. However, if you are looking for a more relevant comparison, you should find out the average ROI, CoC, and cap rate of your given location. Doing this helps factor in different features that are associated with returns, such as location, economy, property type, property investment strategies, and more.
How Can You Find Properties with an Above Average Return on Investment?
There’s one way you can find properties with an ROI higher than average: using an investment property calculator. An investment property calculator searches for properties based on an investor’s input and data provided by predictive analytics. If you were to use Mashvisor’s investment property calculator, you can search for properties with the highest estimated ROI, CoC, and cap rate. The calculator can also alter searches based on various features, such as budget, investment strategy, and number of bedrooms and bathrooms. To learn more about the calculator, read this: “Investment Property Calculator for Analyzing Real Estate Investments.” To get yourself started with a 14-day free trial with Mashvisor to use our calculator, click here!