Have you found a rental property for sale that you’re interested in buying as a real estate investment? Before making an offer, you need to make sure that this property will be profitable and actually make you money. You can do this with the help of the ROI formula. The return on investment is a widely used financial measure for the return or gain from an investment. Basically, it estimates how much money is made on investment as a percentage of the cost of the investment. In other words, it shows you how effectively and efficiently investment dollars are being used to generate profits.
In real estate investing, ROI is one of the key metrics to evaluate a property and/or rank the attractiveness of several different investment properties. For real estate investors, it’s important to calculate the ROI to determine whether properties are worth their time and money. In this guide, we’ll break down the ROI formula, outline a few examples of how to calculate the ROI for rental property, and introduce you to an ROI calculator that every real estate investor needs.
The ROI Formula for Rental Properties
The return on investment is most commonly measured as annual income or returns divided by the original capital cost of the investment. To calculate your annual returns as a real estate investor, you would take your monthly rental income and multiply it by 12. Then, simply take that number and divide it by the cost of investment to find the ROI. Of course, the higher the percentage, the greater the benefits earned!
Pretty simple, right? Let’s take an example of calculating ROI for rental property for further clarification.
Simple ROI Formula Example
Say that you’ve found a single-family home rental for sale in your housing market and you want to buy it and rent it out to have monthly rental income. Let’s see if this rental property makes for a profitable real estate investment. The property’s purchase price is $150,000 and you’re planning on renting it out for $2,000 a month (annual returns = $24,000). Following the ROI formula, your return on investment is:
$24,000 / $150,000 = 0.16
Multiply that by 100 to get a percentage, and you get 16% ROI. This percentage is an indicator of how this investment property will perform and what returns you can expect to receive from buying it. After calculating ROI on rental property, you can compare it to other ROIs on similar properties and other investment options in the housing market to see which will yield you the highest return!
Benefits of the ROI Formula for Real Estate
The reason why the return on investment metric is frequently used in real estate investing is that it’s so easy to calculate and understand. Only two figures are required for calculating ROI! As you can see from our ROI formula example, this is an uncomplicated way for real estate investors to decide whether to take or skip investment opportunities.
Furthermore, the ROI metric is versatile despite its simplicity. For example, you might be calculating ROI for rental property to evaluate or analyze its profitability as a real estate investment. However, you can also use this formula to compare returns from different investments properties. In other words, an investor can separate low-performing investments from high-performing investments. This way, you are optimizing your investments by guaranteeing that you put your money in the best property out there!
You can start comparing the ROI of some of the best rental properties right now with Mashvisor. Click here to get started!
Limitations of the ROI Formula
While the above calculation is often very useful to investors, there are also some limitations to the ROI formula that are important to know:
- The ROI formula doesn’t adjust for the level of risk. Investment returns can have a direct correlation with risk depending on the type of property or its condition– the higher the potential ROI, the greater the possible risk. A real estate investor who is targeting a return of 15%, for example, may have to assume a significantly higher level of risk than an investor who’s aiming for a 7% ROI. If you only focus on the ROI figure without evaluating the associated risk, the eventual outcome of the investment property may be very different from what you expected.
- Calculating ROI for rental property can also be difficult when investors have the option of paying cash or taking out a mortgage to finance the investment. To accurately calculate the ROI, certain variables are included or excluded depending on your investment property financing method – which can impact the cost of the investment. For example, when financing with a loan, investors have to include mortgage interest in their calculations. Also, if you don’t include all expected costs (like interest, maintenance, etc.), the ROI formula can give exaggerated figures.
That’s why there are two methods of calculating ROI for rental property:
1) The Cost Method (Cap Rate)
Real estate investors use the cap rate formula when calculating ROI for investment properties bought fully in cash. This method typically measures the property’s rate of return over a one-year period. Meaning it doesn’t give you a full overview of how the real estate property performed in the past several years or how it will perform over the coming years.
To calculate the cap rate of a rental property, simply divide the property’s NOI by its current market value and multiply it by 100 to get a percentage.
Let’s go back to our previous ROI formula example and calculate the cap rate. You first need to find the property’s market value – this is not the same as the purchase price! You can do that by conducting a comparative market analysis or getting the property appraised. For this example, we’ll assume that the property’s market value is the same as its purchase price.
So you’ve paid $150,000 in cash for the rental property. If you collect $2,000 in rent every month, you’ll earn an annual rental income of $24,000. Furthermore, after calculating your annual expenses, let’s say they’ve totaled $5,000. Now, the NOI is the difference between your annual rental income and annual expenses ($19,000). To calculate the cap rate, divide the NOI by the property’s value and multiply by 100:
Cap Rate = ($19,000 / $150,000) x 100 = 12.6%.
This is just a simple example for calculating the cap rate of rental properties. To learn more, read: The Cap Rate Formula and How It Helps Find Profitable Investments.
2) The Out-of-Pocket Method (Cash on Cash Return)
The cash on cash return is generally the most used ROI formula and it’s used by real estate investors who take out a mortgage to finance their investments. The cash on cash return formula is:
To figure out your annual pre-tax cash flow, add the (gross rental income + any additional income derived from the property – vacancy – operating expenses). The next part of the equation is harder. You need to calculate how much cash you’ve actually invested in the real estate property. To do this, add together your down payment, closing costs, and property repairs.
Let’s go back to the $150,000 investment property mentioned in the ROI formula example, but instead of buying fully with cash, you took out a mortgage loan. Typically, mortgage lenders require real estate investors to put a 20% down payment. Assuming this is the case, your costs will include:
- The down payment ($150,000 x 20% = $30,000)
- $2,500 in closing costs
- $9,000 for remodeling
- Total cash invested = $41,500
Now let’s calculate your annual pre-tax cash flow. Here, we have to account for the ongoing costs that come with a mortgage including:
- Assume you took out a 30-year loan with a fixed 4% interest rate. On the borrowed $120,000 ($150,000 purchase price – $30,000 down payment), monthly principal and interest payments would be $573
- Add $200 a month to cover water, taxes, and insurance, making your total monthly expenses $773
- $2,000 monthly rental income ($24,000 per year)
- Monthly cash flow = $1,227 ($2,000 monthly rental income – $773 monthly rental expenses)
- Annual pre-tax cash flow = $14,724
To calculate the ROI, divide annual pre-tax cash flow by your total cash invested and multiply by 100:
Cash on Cash Return = ($14,724 / $41,500) x 100 = 35%
ROI Calculator for Rental Property
Worried that you’ll get confused with all these ROI calculations and get inaccurate results? Then you’ll need to use Mashvisor’s Investment Property Calculator. Basically, this is an ROI calculator for rental property that covers all the different ROI formula methods! In the mortgage section of the calculator, plug in your financing details (down payment, loan amount, loan type, and interest rate).
In the expenses section, add and modify the different One Time Startup Costs and the Recurring Expenses that will incur upon investing in property.
After that, you’ll get an analysis of what kind of cash flow, cap rate, and cash on cash return you can expect to receive from this real estate investment based on the rental income estimate provided to you by the calculator. Not only that, but the provided calculations also include Airbnb analytics! Meaning, our Investment Property Calculator allows you to analyze the profitability of the rental property regarding traditional and Airbnb return on investment. This lets you see which rental strategy yields higher profits in real estate investing.
Want to give it a try? Click here to start out your 14-day free trial with Mashvisor and subscribe to our services with a 20% discount after!
Final Words for Real Estate Investors
Noticed that we got significantly higher figures when using the cash on cash return method as the ROI formula even though it’s the same investment property? Don’t worry, the calculations are accurate – the difference is attributed to the financing method. Remember: how you finance buying rental properties impacts the cost of the investment. As a general rule, the less cash paid up-front, the greater your return on investment. This is why when you finance the investment with a mortgage, you’ll typically have higher cash on cash return.
Investors often debate which formula to use in their investment property analysis. However, the most accurate results come from using all three formulas together. So, to get the best understanding of a property’s potential returns, it’s best to use ROI, cap rate, and cash on cash return. With Mashvisor’s Investment Property Calculator, you can easily do that and find the best properties in a matter of minutes!