Being aware of the potential financial returns of an investment property is the driving force behind a purchase. How can you find out the financial return of a rental property? Through its ROI, of course! But what exactly is ROI? What is a good ROI for rental property? How is ROI calculated? These three questions are what this blog is all about.
What does ROI mean?
ROI, short for return on investment, is the standard metric used to evaluate the returns of an investment. This standard is very comprehensive. It takes many important variables into account including annual rental income, property price, and the expenses of the real estate property. When these variables are put together in an equation, ROI looks like this:
ROI = (Annual Rental Income – Expenses and Costs) / Property Price
Here’s what the variables mean:
- Annual Rental Income: This is exactly what it sounds like. The annual rental income is simply the rental income an investment property generates in a year. It is calculated by multiplying the monthly rental income by 12 or by multiplying the weekly rental income by 52.
Related: How much rental income should you be making?
- Expenses and Costs: Every rental property comes with different expenses and costs, some are recurring and others aren’t. ROI takes all expenses and costs, whether they are property taxes or the costs for new furniture, into account.
- Cost of Property: To truly understand how well a property is doing, its profit (rental income) must be compared to its price. Without doing this, a real estate investor may be deceived into thinking a rental property is performing well, even if it generates high income. But if this income is compared to its price (or fair market value) and is insignificant, the investment property is actually not performing as believed.
What is a good ROI for rental property?
Now that we know what ROI is, a next question must be asked: What is a good ROI for rental property? The answer is pretty straight forward, but for clarity, we’ll illustrate it with a ROI calculation example.
Let’s say you own a pretty successful rental property. It is occupied for most or all of the year, it’s attracting tenants, and its maintenance functions are smooth. It also has high rental income, with a monthly rental income of $3,775. The property’s fair market value is $275,000. This all sounds great, but is the property really providing good return on investment? To find out, we’ll need to calculate its ROI.
Since the monthly rental income is $3,775, the property’s annual rental income is $45,300. Its annual expenses, which include taxes, repairs, renovations and more, add up to $2,000. What’s the ROI for this rental property?
ROI = ($45,300 – $2,000) / $275,000 = 0.157
As a percentage, the ROI for the income property is 15.7%. So, harkening back to the original question: What is a good ROI for rental property? The answer to our example is the same answer to our question. A 15% ROI for a rental property is considered good.
Great! We now know what is a good ROI for rental property. One more issue, however, has not been addressed. How does ROI change depending on the method of financing? What is a good ROI for rental property if the method is different?
The different ways to calculate ROI for rental property
There are two main methods of financing a property: purchasing with cash or through a mortgage. As a result, ROI calculations can differ as well.
Related: Buying an Investment Property: Cash or Mortgage?
Purchasing with Cash
If you can somehow purchase a rental property entirely in cash, then calculating ROI is not too difficult. All you will need to do is use the ROI formula as in the previous example.
ROI = (Annual Rental Income – Expenses and Costs) – Property Price
What is a good ROI for rental property when paying fully in cash? The answer still remains 15%, as the same equation is used.
Using a Mortgage
If you, like the vast majority of real estate investors, decide to invest with a mortgage, calculating ROI has a slight tweak. The result is what’s called the out of pocket method:
ROI = Annual Cash Flow / Total Cash Invested
On the surface, it may seem that this form of the ROI equation is very different from the other used one for cash purchase. The reality is, however, that these calculations are almost the same. In fact, the out of pocket ROI contains a broader definition that could be applied to cash purchases.
This formula uses annual cash flow instead of the difference between annual rental income and expenses and costs. Why? Annual cash flow is merely an extension of the difference, as it also takes mortgage payments into account. The other change in the out of pocket ROI is using total cash invested instead of property price. That’s because the real estate investor has not fully paid down the property when using a mortgage. Instead, when an investment property is fully paid for in cash, the total amount invested is simply its property price.
So, what is a good ROI for rental property when using the out of pocket method? The answer remains to be 15%. The difference is, however, that it is much easier to reach this percentage. Since the total cash invested tends to be much less than the property price (as in cash purchases ROI), the overall ROI is lower. An example could will make this easier to understand.
Let’s say a rental property’s annual cash flow (or the difference between the annual rental income and expenses) is $30,000. The property price is $250,000.
If the property is fully purchased in cash:
ROI = $30,000 / $250,000 = 0.12 = 12%
If the property is purchased with a mortgage and $150,000 has been paid back:
ROI = $30,000 / $150,000 = 0.2 = 20%
Purchasing investment properties with a mortgage will increase the potential ROI of a rental property. Even though a property is fully paid for when purchasing with cash, it can take longer to get the bigger bang for your buck.
Related: How To Do Investment Property Analysis
Knowing what is a good ROI for rental property is vital for real estate investors. Want to know more answers to questions that are equally important to what is a good ROI for rental property? Then head over to Mashvisor, your best investment property advisor.