People decide to invest in the real estate business rather than say stocks, for example, for many reasons. The main reason is that real estate is still considered the easiest way to make money in the US. However, to be able to make money from your real estate investment properties, you need to receive a good rate of return on investment. Now, you may be wondering “What is a good rate of return on investment?”
The answer to this question, as many other important questions in this field, is not a straightforward one. In most cases, you’ll hear the answer “It depends.” But, before discussing what is a good rate of return on investment in real estate, the first thing you need to do is conduct real estate market analysis to measure how much money you can expect to earn from your rental property. There are 3 commonly used metrics for calculating the rate of return on investment in the real estate business.
3 Ways to Measure Return on Real Estate Investment
1. Return on Investment (ROI)
The simplest and most basic way to measure the rate of return and evaluate the efficiency of an investment is the return on investment metric. Successful real estate investors consider ROI the most important number when it comes to the rate of return on investment.
The formula for measuring ROI is: ROI = Annual rental income/Total cash investment
For example, a real estate investor purchased a rental property for $400,000 and paid another $15,000 in closing fees, maintenance costs, etc. This real estate investor charges a monthly rent of $2,500. The ROI for this rental property is:
ROI = 12 x $2,500/($400,000 + $15,000) = 7.2%
2. Capitalization Rate
The capitalization rate (or cap rate, for short) is another popular metric for calculating the rate of return on real estate investments. It describes the rate of return on a rental property that the real estate investor paid for fully in cash.
The formula for calculating cap rate is easy; you simply take the net operating income (NOI) and divide it by the purchase price. For example, let’s say it costs a real estate investor a total of $170,000 to buy an investment property, and he/she decides to rent it out for $1,500 per month. All annual costs related to the investment property sum up to $3,000. Thus, the cap rate calculation would be:
Cap Rate = (12 x $1,500 – $3,000)/$170,000 = 8.82%
3. Cash on Cash Return
A third widely used (probably the most popular) metric for determining the profitability of a real estate investment property is the cash on cash (or CoC) return. CoC return measures the rate of return on your investment property if you paid for it through a mortgage. To calculate it, divide the NOI by the total cash actually invested (down payment).
Let’s say you purchased a $350,000 rental property through a mortgage, with a 20% down payment ($70,000). You collect $1,700 monthly rent, and your annual expenses associated with the property sum up to $4,000. In this case, the cash on cash return would be:
CoC Return = (12 x $1,700 – $4,000)/$70,000 = 23.4%
Do you think the numbers from our examples represent a good rate of return? Let’s look at the possible answers to the question “What is a good rate of return in the real estate business?”
What Is a Good Rate of Return on Investment?
Good Rate of Return in Terms of ROI
A number of factors affect the answer, such as the location, the size of the property, and the risks associated with this real estate investment, in addition to the real estate investor’s personal goal or target return. For some real estate investors, a return of 7.2% on a rental property would be considered a good rate of return. On the other hand, real estate investors with riskier investment properties would not settle for anything less than 40%. On average, real estate experts agree that anything above 15% is a good rate of return on investment in real estate.
Good Rate of Return in Terms of Cap Rate
Once again, there is no straightforward good rate of return in relation to the cap rate. It’s all influenced by the characteristics of the investment property, such as its type, its size, the market, and others. However, in the real estate business, successful real estate investors generally agree that, in relation to cap rate, a good rate of return would be anything above 10%.
Good Rate of Return in Terms of Cash on Cash Return
Just like the previous real estate metrics, a good rate of return in terms of the cash on cash return also varies from one type of investment property to another, and from one location to another. Unlike the other real estate metrics though, real estate experts disagree on the numbers. Some would tell you anything in the range 8-12% of cash on cash return is a good rate of return. Other real estate investors, however, do not recommend investing in a rental property if it doesn’t promise 20% of cash on cash return.
Looking for a Way to Calculate These Metrics?
Do all these numbers confuse you? Are you worried you might end up with the wrong numbers and make the wrong investment decision? Well, put your worries to rest and use Mashvisor’s investment property calculator. This real estate tool provides real estate investors with the ROI, cap rate, and cash on cash return information for thousands of real estate investment properties and entire neighborhoods throughout the US real estate market. Ultimately, Mashvisor’s investment property calculator helps actual and future real estate investors find the best investment properties – with a good rate of return – that meet their requirements and needs to succeed in the real estate business.
The Bottom Line
As mentioned above, a good rate of return on investment in real estate depends on the characteristics of the actual property (such as its type, size, location, etc.) and the local housing market. Generally, you can expect a higher return from a riskier, larger, and more luxurious rental property. Nevertheless, before you, as a real estate investor, make any final investment decisions, you still need to conduct comprehensive real estate market analysis, in addition to investment property analysis to guarantee a good rate of return on your investment properties.
Now that we’ve explored the possible answers to what is a good rate of return on investment with regards to ROI, cap rate, and cash on cash return, these numbers together can help a real estate investor evaluate real estate investments’ performance and decide which property is the best one to make money and guarantees to have a successful career in the real estate business. Read this blog for more information on how to evaluate real estate investment performance using the rate of return on investment.