When evaluating the profitability of an income property, looking at the rental income is not enough. A rental property may generate high rental income, but with pricey costs and expenses, it may not be truly profitable. Instead, what investors need to look at to determine the profitability of a property is real estate return on investment.
With that being said, a common question that investors have is: What is the average rate of return on rental property in the US housing market? We’ll answer this question, break down return on investment in detail, and leave you with important pieces of investment information so that you can find a profitable property.
What Is the Average Real Estate Return on Investment in the US?
First and foremost, what is the average real estate return on investment in the US real estate market? The answer lies with the S&P 500 Index. According to the Index, the average return on investment in the US is 8.6%. The average rate of return heavily depends on the type of rental property. Residential rental properties, for instance, have an average return of 10.6%. Commercial real estate, on the other hand, has an average return on investment of 9.5%.
What Is Real Estate Return on Investment?
In order to understand the importance of the average real estate return on investment, we need to rewind and discuss what return on investment is and the different formulas that can be applied.
Real estate return on investment is a metric that computes profitability while considering the many variables associated with buying and operating an investment property. Its most important factors include rental income, rental expenses, and property price or value. Also known as ROI or rate of return, return on investment is calculated as follows:
ROI Calculation Example
Calculating return on investment will help beginner investors better understand the concept. So, here is a quick example of how to use the real estate return on investment formula:
An Airbnb investment property, worth $330,000, earns $3,600 in monthly income. Over the span of 12 months, the property’s rental expenses are $2,000. What is its return on real estate investment?
ROI = [($3,600 x 12 months – $2,000) ÷ $330,000] x 100% = 12.48%
What Is a Good ROI?
After finding the answer to the previous question, we can focus on another important question: What is a good return on real estate investment? The answer varies based on the area and the specific property type, among other factors. Generally, however, on the national level, a good ROI ranges from 6% to 8%.
What Is Cash on Cash Return?
Even in its standard form, ROI is a useful and valuable real estate metric. However, sometimes rental property investors need to use two derivations of ROI. The first of these derivations is called cash on cash return. Abbreviated as CoC return, cash on cash return is an ROI metric that takes the total amount of invested cash into account. It also differs from the ROI formula by replacing the difference between rental income and expenses with annual pre-tax cash flow. As such, here is how to calculate return on real estate investment as CoC return:
CoC Return Calculation Example
Here is a quick example to test your knowledge of this real estate return on investment metric. A $400,000 single-family property, with $200,000 invested (the rest is covered with a mortgage loan and thus not included in the calculation), generates $20,000 in pre-tax cash flow in a year. What is its cash on cash return?
CoC Return = ($20,000 ÷ $200,000) x 100% = 10%
The key advantage to CoC return is using total cash invested as its denominator. By doing so, real estate investors can use the metric to determine the returns of an investment property at any particular time.
What Is a Good CoC Return?
So, what is considered a good cash on cash return? Similar to ROI, the range depends on many different variables. Nonetheless, the general range is from 6% to 12%.
What Is Cap Rate?
The third most common form of real estate return on investment is cap rate. Cap rate, short for capitalization rate, is similar to CoC return except that it estimates rental property profitability regardless of financing method. This makes cap rate particularly beneficial for property comparison when looking to purchase and invest. While investors can use Mashvisor’s real estate investment calculator to compute cap rate (and CoC return), here is the cap rate formula:
Net operating income, or NOI, is the difference between the rental income and expenses of an investment property. Just as it sounds like, fair market value, or FMV, is the value of the investment property.
Cap Rate Calculation Example
Here is an example to calculate cap rate, which is fairly straightforward. A $275,000 duplex has an NOI of $30,000. What is its cap rate?
Cap Rate = ($30,000 ÷ $275,000) x 100% = 10.9%
What Is a Good Cap Rate?
As is the case with ROI and CoC, the range of good cap rate differs based on location and other factors. The answer to what is a good cap rate is typically between 6% to 12%.
Important Note When Considering Good and Average Return on Investment
Whenever discussing what is considered good and average real estate return on investment, investors need to remember one simple truth about real estate. The fact of the matter is that the three most important things in real estate investing are location, location, and location.
Ultimately, the typical good real estate return on investment ranges and the average rate of return mentioned earlier do not matter. Investors need to focus on what the ranges of good and average ROI are in their investment locations. An investor in the San Francisco real estate market, for instance, should not expect to receive the ROI of a property in an affordable town in the Midwest. By analyzing respective locations, real estate investors will have a more realistic and accurate idea of ROI.
You can learn about your area’s real estate return on investment in just a few clicks. With Mashvisor’s investment calculator, you can analyze any rental market and property in the US housing market. Start your 14-day FREE trial with Mashvisor’s real estate return on investment calculator!