The most important piece of information real estate investors need is the returns on their investments. Without them, you cannot truly know how efficient and profitable your investment properties are. Some investment properties may generate high rental income, but if they have low returns on investment, they are not good investments. If you really want to know how your rental properties are performing, you must know how to calculate return on investment.
Return on investment can have different variables, depending on various factors, mainly depending on the purchase of the property. For this reason, there is more than one way of computing this metric. In this blog, we will show you five methods of how to calculate return on investment:
1.) Return on Investment (ROI)
When calculating return on investment, ROI is used as the standard. In fact, the rest of the methods of how to calculate return on investment are extensions of the ROI calculation. Here is the formula to compute ROI:
ROI = (Annual Rental Income – Costs and Expenses) / Cost of Property
Let’s break down these variables, one by one. Annual rental income is exactly as it sounds like. To calculate this, simply multiply your monthly rental income by 12 or your weekly rental income by 52. The annual rental income is deducted by the sum of costs and expenses associated with the rental property. These may be costs paid at one time only (like closing costs) or costs that are paid as long as you have an income property (like property taxes). The difference between the annual income and the sum of expenses is divided by the cost (or the fair market value) of the property.
While ROI is useful when wanting to know how to calculate return on investment, it does not give the full story. For instance, ROI fails to take into account the method of purchase, whether the property is fully paid in cash or through a mortgage. To count for the method of financing, we use other methods.
2.) Cash Purchases
If you can (somehow) purchase an investment property fully in cash, calculating ROI is not too difficult. All you have to do is use the ROI formula as in the previous point. Let’s use an example.
A rental property costs, or is valued at, $230,000. Its monthly rental income is $850, making the annual rental income $10,200. These two bits of information are simple to compute. The missing one, the sum of expenses and costs, requires more effort to obtain.
Here’s just some of what expenses and costs may cover: property taxes, HOA fees, renovation fees, closing costs, and vacancy costs. The list of expenses and costs is definitely exhaustive, but there’s good news. The majority of these expenses are taxable, reducing the overall financial burden on a real estate investor. Also, you can find out all the expenses of an income property in no time by using Mashvisor. Mashvisor’s interactive investment property calculator provides an accurate summation of your expenses, with the help of predictive analytics.
But back to the topic at hand. Once you have an accurate sum of expenses, you can calculate ROI. For this example, say the final cost of expenses is $1,000. This is what the property’s ROI would look like:
ROI = ($10,200 – $1,000) / $230,000 = 0.04 = 4%
Now that you’ve seen how to calculate return on investment, another question arises. Is this a good ROI? This may depend on the investor and the property, but typically a 15% ROI is considered good.
3.) Out of Pocket Method
So, what if you, like most real estate investors, finance the property through a mortgage? How could you calculate ROI then? To figure that out, we use the out of pocket method. Since most real estate investors purchase investment properties through mortgages, this method is very popular. It also results in higher return on investments, since the property is not fully paid in cash.
To know how to calculate return on investment with the out of pocket method, we use a modified ROI formula:
ROI = Annual Cash Flow / Total Cash Invested
Annual cash flow is essentially the same as annual rental income minus the sum of expenses and costs as in the previous formula. This formula, however, is more commonly applied. The monthly mortgage payment is considered. When the monthly mortgage payment and the sum of expenses are deducted from the annual rental income, the annual cash flow is obtained.
Another difference with this technique on how to calculate return on investment is the total cash invested. Instead of the property price, the total cash invested is a sum of the down payment paid on the property and other purchasing costs, A.K.A. out-of-pocket expenses. In other words, it is the value of how much you currently own of the investment property. This value is what results in a higher ROI than with the standard method.
4.) Capitalization Rate
What if you wanted to know how to calculate return on investment, regardless of how a property was financed? To do that, we use the capitalization rate, or cap rate for short.
Cap Rate = NOI / Property Price
NOI, or net operating income, is derived by subtracting the property expenses from the annual rental income. The property price can refer to the full cost of the property (if paid in full with cash) or the amount invested in cash (when using mortgage). A good cap rate is usually around 10%, and a great one is 12% or more. Cap rate is undoubtedly one of the best ways of how to calculate return on investment.
5.) Cost Method
The final method on this list considers an aspect of real estate investing that the other methods have failed to mention – equity. Here’s the formula for this method:
Cost Method = Equity / Total Cash Invested
Not many real estate investors look at this method when wanting to know how to calculate return on investment. That’s because they tend to see cash flow, and not equity, as their main goal.
For more on all things real estate, stop by Mashvisor! This includes help in calculating the return on investment for your prospective rental properties.