A high return on investment is what makes successful real estate investments profitable. Without a high ROI, a rental property is doomed with low rental income and negative cash flow. It is obviously in every real estate investor’s best interests to increase rental income, positive cash flow, and return on investment to ensure profitability.
Is your return on investment low? Why? And how can you generate a higher return on investment? Read on to learn more!
The Factors of Return on Investment
Before we explain why you might not have a higher return on investment, let’s break down the components of ROI. ROI, in any of its forms, measures the net income of investment properties relative to the investment made. The net income is the difference between rental income and rental property expenses and/or other expenses. Therefore, return on investment, whether in its standard form or as cash on cash return or cap rate, is essentially equal to:
ROI = [(Income – Expenses and Costs) ÷ Cost of Investment] × 100%
Why You Don’t Have a Higher Return on Investment
So, now that we understand the three variables of ROI, we can tackle the question: Why don’t you have a higher return on investment? The truth is there may not be one sole reason why you do not have a higher return on investment. As just mentioned, ROI, in any of its forms, breaks down into three main components:
When one or more of these parameters are skewed in the wrong direction, the result may be below average return on investment, or even low return on investment. Let’s look at some examples to further illustrate this point.
What happens to return on investment when an investment property has little positive cash flow? The result is subpar ROI; it may either be average or low return on investment. Here’s an example:
A $350,000 duplex property only charges $700 in monthly rent per unit. With a sum of $1,000 for annual property expenses, the property’s annual ROI is:
ROI = [($700 x 2 units x 12 months) – $1,000 ÷ $350,000] x 100% = 4.5%
Due to the low amount of rental income, the property suffers from average return on investment. The investor in this example should conduct a real estate market analysis to find out how much rent is appropriate to charge.
Learn More: How Much Can I Rent My House For?
Too Many Expenses
The most common factor holding most investors back from achieving a higher return on investment is not insufficient rental income. It is actually excessive spending on expenses.
Let’s use the last example, adjusting monthly rental income from $700 to $1,000. What would the ROI look like if the sum of expenses increased from $1,000 to $5,000?
ROI = [($1,000 x 2 units x 12 months) – $5,000 ÷ $350,000] x 100% = 5.4%
Once again, the property has a low return on investment. This is likely due to faulty maintenance issues with the property, which are absurdly raising expenses.
Finally, purchasing a property that is too expensive may limit ROI. Let’s see what happens when we double the property price in the example, keeping monthly rental income at $1,000 and annual expenses at $1,000.
ROI = [($1,000 x 2 units x 12 months) – $1,000 ÷ $700,000] x 100% = 3.3%
Return on investment dramatically decreases when a property is too expensive relative to its income and expenses. It is best for investors to search for properties they can properly finance.
How to Get a Higher Return on Investment
The best way to get a higher return on investment is to optimize the potential of all three variables. There is a lot of bad investment advice out there that can lead to real estate mistakes on this front. So, it’s important to do what will logically and practically work. Here are the ways to avoid real estate mistakes and maximize your return on investment.
Maximize and Increase Income
The main way to maximize income takes place before buying an investment property: It is to use a neighborhood analysis and an investment property analysis. Both analyses can be conducted using Mashvisor’s investment property calculator, which you can learn more about by clicking here.
A neighborhood analysis will point investors towards the best real estate markets for profitability in a given area. Investors can then scour through and analyze multiple properties using the investment property analysis. The analysis will project a property’s rental income, occupancy rate, and positive cash flow based on predictive analytics and rental comps. The investment property calculator (pictured below) will also show investors what must be altered to change a property’s low return on investment to a higher return on investment.
Of course, the previously mentioned tips focus on gearing a property for positive cash flow, as opposed to changing a current property. The analysis, however, is still of use. The calculator will, for example, show the investor the most profitable rental strategy for the location of your current investment property.
An investor could also implement other changes for a higher return on investment. These include adding amenities, maintaining high occupancy rate, and taking advantage of tax benefits. To learn more about these tips, read Effective Tips on How to Increase Rental Income.
Reduce and Minimize Overall Expenses
Reducing expenses is another effective way of generating a higher return on investment. Once again, taking advantage of tax benefits, such as depreciation and deductibles, will increase ROI. Constant upkeep of a property will also come a long way in reducing future expenses by preventing larger issues.
Investors should also make sure their financing method does not limit their potential ROI. Not following this tip, in particular, is what typically leads to an average return on investment or even negative cash flow. Using Mashvisor’s investment property calculator also comes in handy when organizing and calculating rental property expenses. Take a look:
Invest in Affordable Properties
The last method of obtaining a higher return on investment deals with the initial total cost of investment. This means searching for the best real estate markets for affordability. You should also use rental comps to make sure you’re not overpaying for a property. Again, this is a preemptive measure for increasing ROI but it is crucial and could be the main reason you don’t have a higher return on investment now.
To make sure you always have a high ROI, click here to start your 14-day free trial with Mashvisor!