The ROI calculation formula is a performance measuring tool used by real estate investors to evaluate the efficiency of their real estate investments or to compare the efficiency of different investments. Calculating the return on investment of your real estate investment property is a key element to succeed in real estate investing. In this blog we will focus on how the ROI calculation formula is used to calculate the return on a real estate investment using different approaches.
In general, the ROI calculation formula is an important analytical tool needed in all kinds of investments. It gives investors an idea on how well their investment is performing. In accounting terms, it is the percentage of invested money returned to the investor after eliminating associated costs, and in real estate terms it is the return on investment after deduction of property related costs such as taxes, mortgage payments, operating costs, etc.
Related: Understanding Real Estate Return on Investment
How to calculate the return on investment
General ROI calculation formula:
ROI = (Income from Investment – Cost of Investment)/Cost of Investment
Income from investment may include the following figures, depending on the method chosen to calculate ROI:
- Annual rental income: This is simply the monthly rent multiplied by 12.
- Property value or equity: This is only available when the property has been sold.
- Appreciation of real estate property: This is the value gained over time.
Cost of investment includes:
- Initial cash investment.
- Property taxes, insurance costs, and mortgage payments.
- Maintenance and repairing costs.
The cost method: CAP rate
The cost method assumes that a real estate property is purchased outright with cash, without any financing. The ROI calculation formula is used by dividing the net operating income (NOI) of a rental property by the total investment originally made. This ROI is called net capitalization rate, or cap rate, a very important real estate metric used to measure the performance of a real estate investment and often to evaluate a real estate property.
For example, assume you pay cash for a $150,000 rental property. You also pay $15,000 for renovation. Therefore, your total investment is $165,000. Assume you rent out your real estate property for $1,500 a month, giving you an annual rental income of $18,000. Two expenses that you cannot avoid are property tax and insurance, so let’s assume both are $200 a month, or $2,400 per year.
NOI = Annual Rental Income – Expenses = $18,000 – $2,400 = $15,600
Total Investment = $150,000 + $15,000 = $165,000
ROI or Cap Rate = $15,600/$165,000 = 0.0945 or 9.45 %
The cost method is straightforward and can be easily used when buying a rental property. However, it can get more complex if more variables are considered such as repair and maintenance cost and appreciation or depreciation of the real estate property value.
Related: Become an expert on real estate investing: What is a good ROI for rental property?
The out of pocket method
The out of pocket method uses financed transactions in the ROI calculation formula. Assume you take out a mortgage and make a 20% down payment instead of paying cash. Using the same numbers of the example above, your costs are $30,000 for the down payment ($150,000 x 20%) and $15,000 for renovation. Therefore, the total out of pocket expenses you have to pay are $45,000.
To calculate the monthly mortgage payment, assume you took a long-term loan for 30 years with a fixed interest rate of 4%. On the borrowed $120,000 ($150,000 – $30,000), the monthly mortgage payment would be $570 ($6,840 annually). Use a mortgage calculator to estimate this number. Finally, assume property tax and insurance expenses are $2,400 per year and annual rent income of $18,000.
NOI = Annual Rental Income – Expenses = $18,000 – $6,840 – $2,400 = $8,760
Out of Pocket Investment = $45,000
ROI = $8760/$45,000 = 0.195 or 19.5%
As a general rule, the less cash you put into a real estate investment and the more you borrow money, the greater your ROI will be. Therefore, the out of pocket method is more preferred by real estate investors because it yields higher ROI results. However, the ROI calculation formula can get more complex if a real estate property is refinanced or a second mortgage is taken out.
Some real estate investors add equity into the equation, but it should be noted that equity is not accessible unless the real estate property is sold, only then it can be added to the annual rental income.
Cash on cash return on investment method
The cash on cash return on investment method is similar to the out of pocket method, the only difference is that tax expense is not included in the net operating income calculation. It is a simple measure of investment performance calculated as cash flow before taxes divided by the initial investment.
Cash Flow Before Taxes = Net Operating Income – Annual Mortgage Payment
Cash on Cash ROI = Cash Flow Before Taxes/Total Cash Invested
The cash on cash ROI gives real estate investors a good idea about their real estate investment’s first year financial performance. However, cash on cash return has many limitations and should be used with other ROI calculation formula and more in-depth analysis when analyzing a real estate investment.
Related: How to Calculate Return on Investment in Real Estate: 5 Different Ways
Conclusion
There are several approaches to use the ROI calculation formula, the choice of the method depends on the financing of the real estate investment and the variables considered. But regardless of the ROI calculation formula, it is important to use the same approach to all investments in order to get accurate comparisons. For example, if equity is included in evaluating one property, then it should be included when calculating ROI for other real estate properties. One last advice: always use different performance indicators when analyzing the efficiency of a real estate investment, these include but are not limited to: internal rate of return (IRR), net present value (NPV), and cap rate.
Mashvisor’s investment property calculator provides users with real estate metrics that every real estate investor needs to succeed in real estate investing.
