Calculating the return on investment for a rental property is a fairly simple, yet absolutely crucial part for guaranteeing the success of your real estate investment.
Any investor, whether in real estate or any other industry, knows that the only way to guarantee the success of an investment is to calculate the return on investment before paying for the property that they want to purchase.
Rental properties, of course, are not an exception.
While the concept of the return on investment is a simple one to understand for anyone investing in real estate, beginner investors sometimes don’t realize that there are multiple methods for calculating the return on investment depending on the metric that they want to use and the information that they’re trying to get out of it.
Also, since rental properties are most popular among beginner real estate investors, I will use simple language that is easy to understand by beginner investors looking to purchase a rental property to start generating an income.
Related: The Beginner’s Guide to Rental Property Analysis
So, in this article, I will be talking about the different metrics that are most commonly used for calculating the return on investment for rental properties, how to calculate them, and what the best tools to use when investing in rental properties are to guarantee the success of your investment.
Return on Investment: Which Metrics to Use?
The return on investment is a simple concept: It is the amount of money that you will generate from your investment versus the amount of money that you’re spending on it.
Using this simple definition, if you’re investing $100,000 in a property that generates $10,000 every year, that property’s return on investment would be 10% each year.
However, when dealing with rental properties, there are other factors that need to be included in the calculations, such as the occupancy rate of the property, the one-time and recurring expenses, and the mortgage that you use for purchasing the property.
Since there are multiple factors that can affect the return on investment of a rental property, multiple metrics were created for calculating the return on investment that will tell you different things about the profitability of your investment property.
The two most common metrics that are used for calculating the ROI of rental properties are the cap rate and the cash on cash return.
The cap rate (capitalization rate) is a metric that is used to calculate the return on investment of a rental property based on its overall value, and it does not account for the method of financing used or the actual amount of money you’ve invested in a property.
This metric is most commonly used when comparing several rental properties to determine their profitability before seriously considering any of them for investment or the amount of mortgage you need to take to purchase them.
Related: What Is Cap Rate in Real Estate Investing? A Simple Guide
The cash on cash return, on the other hand, calculates the return on investment based on the amount of cash that you want to invest in the property, leaving out any amount of borrowed money from the calculations.
The cash on cash return is a more reliable metric to use for analyzing a single property or a small number of rental properties if you have a solid idea of the amount of actual cash that you will be spending on each property.
Return on Investment Metrics: How Are They Calculated?
To calculate the cap rate and the cash on cash return metrics, there are certain elements that you need to figure out first that will be included in the calculations:
- Property’s price
- Property’s rental income
- Occupancy rate
- Cash/mortgage
- Mortgage amount
- Mortgage duration
- Mortgage interest rate
- One-time startup costs
- Recurring expenses
While this might seem like an overwhelming amount of information to gather for first-time buyers and beginner investors, there are multiple tools that you can find online to help you get most of this info.
Once you’ve gathered this data, you will need to calculate the net operating income of the property to simplify the process.
The net operating income of a rental property is the amount of money the property will generate each year minus all annual expenses. This means that the NOI is straightforwardly the amount of money that the property will generate or cost you each year.
Calculating the NOI is a very simple process. You take the property’s annual rental income and you multiply it by its occupancy rate to get an accurate measurement of the amount of money it will generate each year. Then, you deduct all the expenses that will incur on the property each year. This includes mortgage payments and interest rates.
While the mortgage might make it a bit more complicated to calculate the expenses, there are several mortgage calculators that you can find online to know the exact amount of money that will go towards paying down your mortgage each year.
Now, let’s look at how the cap rate and the cash on cash return are calculated.
The cap rate’s formula is as follows:
Cap Rate = (NOI / Property’s Price) X 100
Since the cap rate does not account for the method of financing used, when calculating it you should leave out the mortgage payments from your NOI calculation and assume that you’re paying for the property using all cash.
The cash on cash return’s formula is as follows:
Cash on Cash Return = (NOI / Cash Invested) X 100
When it comes to the cash on cash return, you only need to include the actual amount of cash that you’re paying from your own money. So, if you’re getting an $80,000 mortgage to pay for a $100,000 property, you will only use the $20,000 in the calculation.
Both metrics use a percentage based value for their results. This is because both metrics will tell you the amount of money that your rental property will generate each year as a percentage of the property’s total price or the amount of cash you’ve invested in it respectively.
Related: Cap Rate vs. Cash on Cash Return
Return on Investment: What Tool to Use?
When it comes to calculating the return on investment for rental properties that you want to invest in, no tool does it better than Mashvisor.
Mashvisor is a real estate analytics platform that specializes in helping investors find rental properties for sale and analyze them based on the return on investment that they’re projected to have. The platform focuses on the two metrics (the cap rate and the cash on cash return) as the main methods for assessing the properties, and it provides you with pre-calculated metrics for all properties as well as the averages per area to help you analyze, compare, and identify the best investment properties on the market.
Mashvisor’s rental property calculator is an interactive tool that includes a mortgage calculator, an expenses calculator, and a rental strategy calculator. All of these calculators are connected with one another, so any changes you make to one of them will immediately be reflected on the others. This allows you to easily modify values, add or remove certain expenses, and customize the amount of mortgage and its type to get the most accurate results on your return on investment calculations.
If you haven’t already, make sure to check out Mashvisor’s platform and see how you can use it to turn three months of research into 15 minutes with the use of predictive analytics and easy-to-use tools and features. With this platform, beginner real estate investors can make professional-grade investment decisions in a matter of minutes without having to go through the hassle of data gathering, calculations, and spreadsheet comparisons.
