Investing in real estate is all about making money. Investors buy rental properties, rent them out to tenants, and receive rental income in return. Estimating how much rental income you will earn before you buy a rental property is obviously important. However, it isn’t the most accurate measure of profitability. In order to determine actual profit, you’ll need to calculate the rate of return on a rental property. In today’s blog, we’ll show you how to conduct a rate of return analysis in real estate.
What Is Rate of Return?
Rate of return (ROR) is a metric that measures the current profitability of an investment property. It can also be used to project expected rental property profitability. ROR is a more accurate measure of profit than rental income for many reasons. Firstly, the rate of return measures income or net income relative to the investment property’s value or cost. Secondly, ROR can take various costs and expenses into consideration. As a result, it calculates net returns, as opposed to gross income.
Naturally, this leaves real estate investors wondering: What is the rate of return formula? The truth is there is no universal measure of ROR. There are different forms of ROR, depending on the financing method and calculation purposes, among other factors. The three most commonly used in a real estate rate of return analysis include return on investment, cap rate, and cash on cash return.
1. Return on Investment
The first measure in a rate of return analysis is the return on investment. Also known as ROI, it is always expressed as a ratio or a percentage. ROI is calculated as:
As you can see, the return on investment depends on two variables. Annual returns represents income generated from a rental property. It is calculated as monthly income multiplied by 12. Then, you can divide your annual returns by the cost of the investment to estimate ROI.
Related: Learn How to Calculate Annual Rate of Return for Rental Property
Here’s an example to better understand ROI. Let’s say you own a $300,000 rental property that generates $50,000 in annual rental income. What is the property’s return on investment?
ROI = $50,000 ÷ $300,000 = 16.7%
Return on investment is an integral part of a rate of return analysis. However, it does come with a limitation. While ROI is great as a rough estimate of profit, it ignores a crucial component – property expenses. This means it also doesn’t factor in the type of investment property financing a real estate investor may be using to complete the purchase. For a rate of return analysis that considers cash or mortgage payments, we turn to cap rate and cash on cash return.
2. Cap Rate
If you plan on buying an investment property with cash, the cap rate is the ideal ROR metric for you. Cap rate, short for capitalization rate, computes profitability relative to a property’s fair market value. Here is the cap rate formula:
If you are an experienced real estate investor, you might have noticed something. The cap rate formula is a derivation of the ROI formula. While its main variables differ, they are meant to represent the same concepts. ROI, for instance, uses annual returns in its numerator. Cap rate, on the other hand, uses net operating income (NOI). Unlike annual returns, NOI considers property expenses in its calculation. Specifically, NOI is the difference between annual rental income (or annual returns) and the sum of vacancies and operating expenses. Financing payments, however, do not fall into the NOI calculation. In addition, the cap rate formula has the fair market value (FMV) in its denominator, while ROI does not. Nonetheless, FMV could be the equivalent to property price in this formula.
Cap Rate Example
Suppose your rental property has an FMV of $350,000. If its vacancy and operating expenses are $5,000, and the property’s annual rental income is $30,000, what is its cap rate?
Cap Rate = ($30,000 – $5,000) ÷ $350,000 = 7.14%
Overall, calculating the cap rate is a rate of return analysis that looks at profit regardless of how investment property is financed. Mathematically, this is the same as buying a property fully with cash. Therefore, it is particularly useful for property comparison during an investment property analysis.
3. Cash on Cash Return
If you, like the majority of investors, are buying investment property with a mortgage, you’ll need a better rate of return analysis metric. Buying an income property through a loan will yield significantly different returns than buying with cash. To measure your actual returns, you’ll need the cash on cash return, or CoC return for short. As mentioned earlier, the cap rate does not consider the financing method. Cash on cash return, on the other hand, does exactly that.
Related: Is Capitalization Rate or Cash on Cash Return the Better Real Estate Metric?
Here is how you can calculate cash on cash return:
Just as the cap rate is derived from the ROI formula, CoC return is an extension of the cap rate formula. Annual pre-tax cash flow might seem like a vastly different variable than NOI, but it really isn’t. Annual pre-tax cash flow is simply the difference between net operating income and debt service. Debt service refers to the amount of principal and interest of a mortgage. Also, cash on cash return utilizes total cash invested as opposed to FMV. By using a mortgage to finance a property, you do not fully pay for the property at the initial purchase, as you would by financing with cash. Therefore, you would compare your profit relative to the amount you invested in it instead of FMV. Finally, note that if you are buying a property with cash and used the CoC return formula, the result would be the exact same as that from the cap rate formula.
Cash on Cash Return Example
Like the other two rate of return analysis metrics, it’s easier to understand how to go about calculating cash on cash return with an example. Let’s say you’ve invested $250,000 in a single-family rental. During the year, your pre-tax cash flow is $25,000. What is the investment property’s cash on cash return?
Cash on Cash Return = $25,000 ÷ $250,000 = 10%
How to Conduct a Rate of Return Analysis in Minutes
As you can see, conducting a rate of return analysis requires a lot of math and time. Firstly, you would have to obtain the needed property data, which is hard to come by without the proper tools. Then, for every investment property for sale you are interested in, you would have to perform a rate of return analysis. Luckily, though, you don’t have to do this and waste time using rate of return analysis spreadsheets. Instead, you can CLICK HERE to start your 7-day FREE trial with Mashvisor’s rate of return calculator!
Related: The Best Investment Property Return Calculator for 2020
Mashvisor’s calculator estimates ROR, specifically the cash on cash return and cap rate, for any property in the US housing market. It does so for both traditional and Airbnb rental strategies. The calculator also adjusts results based on user inputs, such as financing methods. Mashvisor’s rate of return calculator cuts months’ worth of a rate of return real estate analysis down to a matter of minutes!