If you’re just starting your career in the real estate investing business, you will definitely come across a number of important terms which you need to understand in order to become the best real estate investor, one of which is the rate of return (RoR) on investment properties. This guide is the first of a series of blogs designed to help you understand everything you need to know about the rate of return on investment, in addition to introducing other important related terms that you should familiarize yourself with to succeed in real estate investments. How about we start with defining rate of return?
What Is a Rate of Return in Real Estate Investing?
The rate of return is simply the amount of profit you receive from the investment property over a period of time, calculated in the form of a percentage. This percentage could be positive, indicating that you’re making a profit from your investment, or it could be negative, meaning you’re actually losing money from your investment, which is something no real estate investor wants.
Why Does Rate of Return Matter?
There are a number of reasons why it is important for a real estate investor to calculate the rate of return on investment. After all, how would you be able to determine whether or not the initial investment you made was a wise choice?!
Everyone knows that the best way to make money in real estate investments is to buy a real estate investment property at a great price and sell later in the future for more than you initially paid. Figuring out the right price for your investment properties requires you to determine how much profit you want to earn when you sell them. How can real estate investors know that? The answer is by calculating the rate of return on the investment property (ROI).
Calculating the rate of return on investment will provide you with important information that can be used for future investments. For example, if you invested in a rental property that generated a positive cash flow after a specific time period, this will encourage you to purchase more of that investing property. Similarly, if the rental property caused a continual loss (negative cash flow), the wise thing to do would be to search for a better performing investing property.
Furthermore, calculating the rate of return on investment is useful to gauge your investment and decision making skills. Every real estate investor wants to invest in properties which create a gain, or profit. So, if you’re repeatedly not making money from your real estate investments, then you would know that your investment was not a wise decision and you should be thinking of ways to change your investment strategies. The best real estate investors are those who not only know how and when to make investments, but also know when to change their strategies.
With a firm understanding of the rate of return calculator (a kind of an investment property calculator, also called a rental property calculator), you can manage and monitor your investment properties at different stages to determine the outcome of your real estate investments. In turn, this will lead to gaining the skills necessary to become a successful real estate investor.
Rate of Return Calculator
The rate of return calculator is a real estate investment tool that enables you to estimate the profit or loss on your investment. The basic formula for calculating ROI is:
ROI = (Gain from Investment – Cost of Investment)/Cost of Investment
For example, let’s say you invested a total of $50,000 into the investment property, and the total profits you made from your investment sum up to $70,000. In this case, the rate of return on your investment is:
ROI = ($70,000 – $50,000)/$50,000 = 0.4 = 40%
Remember, this is the simple rate of return formula, and as we can see, it is very general and includes a lot of estimates and unproven numbers. There are other means used to determine the return on investment (ROI), mainly the cap rate and the cash on cash return.
Calculating ROI through Cap Rate
The capitalization rate (or cap rate, for short) is a rate of return calculation that measures profitability by relating the investment property’s purchase price to the rental income which the property is expected to generate. To calculate the cap rate of your investment, divide the net operating income (NOI) of the investment property by the current market value of the property (purchase price) as shown in the formula below:
Cap Rate = Net Operating Income/Current Market Value
Here we introduce a variable that is essential in real estate investing which could be unfamiliar to beginner real estate investors, and that is the net operating income. The NOI of a property is the difference between its annual rental income and its operating expenses including maintenance, management, utilities, and more.
For example, if a real estate investor buys a property for $900,000 and expects that the NOI will be $125,000 per year, the capitalization rate of this investment is:
Cap Rate = $125,000/$900,000 = 0.1389 = 13.89%.
This indicates that the rate of return the real estate investor is earning from his/her investment property is 13.89%.
Cap rate is not only used to measure the rate of return on investment properties; it is also useful to measure how risky the real estate investment is. Higher cap rate means a higher level of risk, thus higher prospected profitability, and vice versa. This helps real estate investors compare different investment properties and evaluate whether an investment is worth their while or not. Another use of this rate of return measure is to check whether or not the investment is improving over a period of time.
Calculating ROI through Cash on Cash Return
Cash on cash return (or CoC) is another rate of return measure; however, this method calculates the cash earned on the cash invested in a real estate property. When buying an investment property, a real estate investor might put down 10%, for example, as a down payment. In this case, we use cash on cash return to measure the rate of return the investment property made in relation to the down payment only. Based on this, the formula for cash on cash return is as follows:
CoC Return = Annual NOI/Total Cash Investment
Let’s take an example: A real estate investor had put down $60,000 as a down payment for an investment property, and his annual NOI was $15,000. Here, the cash on cash return would be:
CoC = $15,000/$60,000 = 0.25 = 25%
What this means is that the rate of return that the real estate investor receives on the cash actually invested is 25%.
Generally, real estate investors use cash on cash return in commercial real estate investments to evaluate their long-term performance and determine whether they’re profitable or not. Furthermore, this rate of return measure is the best for forecasting cash distribution and potential future cash flow over the life of the investment.
Mashvisor’s Investment Property Calculator
Mashvisor’s investment property calculator is a tool that enables real estate investors to search for investment properties with a click of a button and provides them with the most accurate results possible. Not only that, Mashvisor also provides real estate investors with detailed neighborhood analysis in the city of their choice, and complete property analysis after selecting the neighborhood.
Mashvisor’s investment property calculator calculates the previously mentioned real estate metrics – cap rate and CoC return – in addition to the potential rental income and positive or negative cash flow. Needless to say, this is the best tool for real estate investors to calculate the rate of return on investment.
What Is a Good Return on Investment (ROI)?
This is an important question in real estate investments; however, it doesn’t have a straightforward answer. Different real estate experts will give you different answers, and the easiest answer to this question would be “It depends” – on the size of the investment properties, the location, the risk associated with the investment, etc. But this is not really useful for a serious real estate investor, right?
There is more than one way to calculate the rate of return on investment, so there is more than one answer to the question what is a good return on investment. Some real estate investors with safe investment properties will be perfectly happy with a 6% ROI, while others with riskier properties would not go for anything less than 40% ROI. On average, anything above 15% is a good return on investment (ROI).
When calculating the rate of return using cap rate, many real estate experts agree that a good ROI is usually around 10%, and a great one is 12% or more. However, when calculating the rate of return using cash on cash return, real estate experts have different opinions on what is considered a good ROI. Some say that anything in the range 8-12% is good, whereas others would not consider the investment property if it doesn’t promise them 20% return on investment.
Tips to Improve Your Rate of Return on Investment
Know Your Risk
The first and best advice always given to real estate investors is to do research. As previously mentioned, cap rate measures how risky your investment is – the higher the cap rate, the higher the level of risk, thus the higher the profitability, and vice versa. Thus, use the rate of return calculator to measure and understand the risks that come with buying a real estate property before stepping into the real estate business expecting a high rate of return on investment (ROI).
Minimize Vacancy Rate
Having a vacant property is something no real estate investor wants because as long as the property is empty, it is not generating any return. The best way to minimize vacancies is to find great tenants who are ready to rent the property in the long term and are capable of paying the monthly rent. To locate these tenants, you need to use innovative marketing techniques and technology and build a good relationship with these tenants not only to keep them longer but also to ensure that your investment property is well maintained by the occupants. In this way you make sure you’re not generating a negative return or losing money.
Reduce Your Expenses
Try to spend as little as possible on your rental property – within a reasonable limit – in order to make extra returns. For example, you don’t have to hire a professional property management company to take care of your property; you can do all the management work on your own. In addition to that, keeping regular maintenance of the property is one of the best ways that save you money in the long run and improve your rate of return.
Add New Amenities
One of the best ways to improve the rate of return on investment is to add new amenities that you didn’t have before. This will not only make you able to charge more rent from tenants but will also keep your tenants satisfied. You do not have to go overboard; just add something simple like a toaster or a coffee machine. The increase in rent will not be drastic, and the gain may not seem significant, but it will make a huge difference in the long term.
Provide Additional Services
You could improve your rate of return on investment by providing tenants with additional services, such as cleaning services, storage, garage, or a parking space. Real estate investors with the best rental properties offer tenants something special that others in the area do not offer. In this way, the investor will be able to improve the rate of return from the additional service and still be ahead of competitors.
The Bottom Line
Every real estate investor who enters this field has the same purpose – to make a profit. The profit or gain you receive from your investment properties over a period of time is the rate of return on your investment property. Understanding and calculating the rate of return is important for real estate investors to manage and monitor their investments at different stages and determine whether or not any real estate investment is a wise choice.
You can calculate the return on investment (ROI) using a rate of return calculator, a cap rate calculator, and a cash on cash return calculator. Don’t forget to head over to Mashvisor and use Mashvisor’s investment property calculator to measure these metrics and others, which will provide you with accurate results on the rate of return on investment properties with only a click of a button.
To continue learning about the rate of return on investments, we advise you to read the following series of blogs starting with this one to discover the three types of return on investment in real estate.