Investing in rental properties continues to be one of the best ways to make money and grow wealth over time. But that doesn’t mean that just any rental property out there is bound to reward you with the profits that you’re hoping to achieve. That’s simply because properties are not created equal and every real estate investor has his/her own idea of what a good return on investment is. Meaning, calculating ROI is the first step you need to do before deciding to buy a property to rent out. This allows you to determine its efficiency as an investment compared to others in the real estate market and make smart decisions accordingly. Now you must be wondering: how to calculate ROI on rental property?
Some will give you the general ROI formula and claim it calculates the return on any real estate investment property. However, the truth is, there are other formulas that you need to know for calculating ROI in real estate. That’s because different investors have different criteria regarding how they’re planning to make the investment. For example, some might be able to buy rental properties fully with cash but others might prefer taking out a mortgage loan to finance the real estate investment. These investors can’t use the same formula for calculating ROI because one can exclude financing expenses while the others can’t or he/she will get false results.
This is why there are three methods that property investors use to estimate ROI in real estate. These are the simple ROI method, the cost method (cap rate), and the out-of-pocket method (cash on cash return). If you want to get the best understanding of a property’s potential rate of return, it’s recommended that you use all three methods.
In this guide, we’ll explain exactly how to calculate ROI on investment property using each method and formula. Furthermore, we’ll introduce an online tool that will help you make the ROI calculation faster and easier. This tool is a must-have for beginner real estate investors (and experienced investors too!). So keep reading to learn all about it.
How to Calculate ROI Using the Simple Method
This is the basic formula for ROI calculation and it can be used to calculate return on any type of investment, be it real estate properties or another. Property investors use this method to determine how well a piece of real estate is performing by dividing the annual returns by the total investment. Meaning, the ROI formula includes both the cash you invested and any debt you’ve leveraged on the property. Also, you can use this formula to calculate ROI in real estate whether you’re investing in a rental or a buy-and-hold real estate property.
For example, say the total investment needed to buy a single-family home was $150,000 and the annual return you make from renting out this property sums up to $24,000. In this example, the rate of return on your investment is ($24,000/$150,000 = 16%). This 16% is considered a good return on investment on an income-producing asset. You can now compare your property to similar ones in the housing market or to other investment options to see which yields the highest ROI.
Related: What Is a Good Return on Real Estate Investment?
It should be noted, however, that the simple method of how to calculate ROI is not always reliable as it’s very general and includes a lot of estimates. This is why it’s important for real estate investors to use other methods and metrics when analyzing rental properties to get more accurate estimations before making a purchase.
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How to Calculate ROI Using the Cost Method
Cap rate measures the rate of return on a property that you’re planning to buy fully in cash. It measures the profitability of a rental property by calculating the ratio between its net operating income (NOI) and its purchase price. Real estate investors also use the cap rate to compare similar real estate investments – for example, two single-family homes for sale in the same housing market. You can calculate an investment property’s cap rate using a Cap Rate Calculator or by hand by following the above formula. If you want to know how to calculate ROI using the cost method by hand, here’s an example:
Say you want to find the cap rate of a house for sale that is worth $120,000. To find out the property’s net operating income, calculate rental property cash flow after subtracting operating expenses, but before principal and interest payments, capital expenditures, depreciation, and amortization. For this example, assume the NOI is $8,000. Therefore, you can expect to have a cap rate of ($8,000/$120,000 = 6.6%) from this rental property. This is the rate of return on rental property if you were to pay for it fully in cash.
Related: What’s a Good Cap Rate for Investment Properties?
But what if you don’t have this amount of cash ready for investing in real estate. Most beginner real estate investors, after all, prefer to finance their purchase with a mortgage loan (or other investment property financing options). If that’s the case for you, you should not use the cap rate formula for calculating ROI because it does not factor in financing expenses. In order to get more accurate and realistic estimations, you need to use this next method for calculating ROI on rental property.
How to Calculate ROI Using the Out-of-Pocket Method
This is considered to be the most-used real estate investment analysis metric, understandably since most investors prefer to leverage their investments by taking out a mortgage loan. Since you’re not paying the full purchase price, you’ll want to know how to calculate ROI on the money that you’ve actually invested. The best and easiest way to do so is by calculating ROI using the cash on cash return formula. It expresses the ratio of annual return (or pre-tax cash flow) to the amount of actual cash invested. So, unlike the cap rate, this return on investment formula takes into consideration the debt on a property.
Let’s see what ROI you can expect from the investment property in our previous example if you were to finance it with a 30% down payment. Meaning you’ve only paid $36,000 of the property’s purchase price. Say that you’ve paid $2,000 in closing costs and $8,000 in remodeling the house after buying it. This means you’ve invested a total of $46,000. Now, to calculate the property’s annual return, simply subtract loan costs from the NOI. Say that your final annual return estimate is $4,400. Divide that by your total investment and you’ll get a 9.5% cash on cash return.
Related: What Is a Good Cash on Cash Return?
Introducing the Real Estate ROI Calculator
Today’s real estate investors use the best investment tools available to them that make the decision-making process easier and faster. One of these tools is the Real Estate ROI Calculator (also known as the Rental Property ROI Calculator). This tool uses predictive analytics to provide readily-calculated estimates of the ROI from a property in terms of both cap rate and cash on cash return. If you’re using Mashvisor’s calculator, then you’ll get even more profitability estimates including the comparable rental income, cash flow, and a breakdown of property expenses.
Also, you can input/adjust your own numbers and financing information and Mashvisor will immediately recalculate the numbers and show new, more personalized results of the ROI. Not only that, but you will also get both the traditional and Airbnb ROI on rental property to decide which is the optimal rental strategy.
Needless to say, using a Real Estate ROI Calculator is highly recommended to investors wondering how to calculate ROI and ensure a good return in terms of cap rate and cash on cash return. To learn more about this ultimate investment tool for calculating ROI on rental property, click here.
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