Few things are more important to a real estate investor than getting a good ROI. What does ROI stand for? Return on Investment.
After all, the basis of all investments – stocks, bonds, or real estate – is to make money and increase wealth over time. So it’s safe to say you’re hoping to turn a profit from investing in real estate. Those who can accurately calculate the potential profits from an investment property before acquiring it are more likely to increase their chances of success. One of the best indicators investors use to do so is the ROI. Thus, if you’re unsure whether or not to proceed with a property investment opportunity, then keep reading our complete guide for real estate investors where you’ll learn:
- What Is ROI in Real Estate?
- How to Calculate ROI in Real Estate
- What Is a Good ROI in Real Estate?
- What Is a Real Estate ROI Calculator?
Return on investment is the ratio between the profits and costs of an investment. It measures how much money is made on investment as a percentage of the investment’s cost. Investors use ROI to evaluate the profitability of an investment or to compare the profitability of different investments.
Based on the ROI definition, you
can tell why calculating ROI on rental property is important. Essentially, the
return on investment represents the potential of income-producing
assets. Investors who know the rate of return on the money they’ll invest
can better decide whether or not to undertake the investment. This is why real
estate ROI has become synonymous with today’s best indicators for determining
whether or not real
estate deals are worthwhile. A higher ROI suggests the profits you’ll
receive from an investment property compare favorably to its cost.
Another purpose of ROI in real estate is for comparison. A beginner real estate investor planning to buy his/her first rental property should use the ROI calculation to compare the numerous investment opportunities available in the housing market. Naturally, not all homes for sale have the same probability for profit as rental properties. By calculating ROI on each one, you are able to determine which one is best to invest in and make smart decisions accordingly. Seasoned real estate investors also use ROI to compare different investments within a portfolio. Usually, the investment with the largest ROI is prioritized.
How to Calculate ROI in Real Estate
Now you know what is ROI and why it’s of utmost importance for a real estate investor in today’s market to calculate rental property ROI before making investment decisions. But you might be wondering exactly how to calculate ROI on investment property. Don’t worry, the ROI formula is actually simple and easy to understand. Based on the ROI definition, the return on investment formula is as follows:
Here are 4 simple steps to calculate ROI on rental property:
- Calculate the expected annual rental income
Simply estimate how much you expect to make over the course of a year on rent from the investment property (monthly rental income x 12).
- Subtract rental expenses from the annual rental income
Take that annual rental income you just calculated and subtract any expenses you expect to incur including mortgage payments, maintenance, etc. The number you end up with is known as your cash flow.
- Add the equity you stand to make in the property
Every payment towards the mortgage principal will increase your equity in an investment property. So calculate equity and add it to cash flow to get your net income (gain from investment).
- Divide your net income by your total investment
Finally, go on to run the numbers following the ROI formula and divide the gain by the total cost you paid for the investment to find your rental property ROI.
For more details, read: How
to Calculate the Rate of Return on a Rental Property
Limitations of the ROI Calculation
While the return on investment formula is easy enough to calculate, keep in mind that there are a number of variables that come into play with real estate investments that can affect ROI. These include expenses like repair, maintenance, utility rates, and property taxes which may increase with time and, thus, reduce ROI on rental property. Furthermore, the investment property financing method and financing terms (amount of money borrowed and interest rate) impact the cost of investment which, in turn, changes the ROI calculation. Naturally, the ROI is higher if investment costs are lower. Also, the ROI calculation assumes the real estate property is rented out for all 12 months of the year. In many cases, however, vacancies occur in between tenants and the lack of income for those months must be factored into your calculations.
Due to these complications, the ROI formula should not be used on its own when calculating potential profits. To help real estate investors get a more accurate snapshot of rental property profitability, two methods for calculating ROI in real estate were created:
#1. Cost Method (Cap Rate)
The cost method in real estate is used to calculate ROI for cash transactions (i.e. investment properties that were purchased fully with cash). It does so by dividing the property’s net operating income (NOI) by all costs related to its purchase (the total investment). Calculating ROI on rental property that’s purchased with cash is easy because you don’t need to include monthly interest payments as there are none. Thus, the cap rate formula to calculate ROI using the cost method is:
For example, assume you bought a $100,000 house in cash and paid $1,000 in closing costs and another $9,000 for remodeling. This makes your total investment $110,000. Say that you’ve rented out the property for $1,100 per month and a year later, you’ve made $13,200 in rental income. Let’s deduct $4,000 that was used to cover rental expenses like property taxes, insurance, vacancy, and maintenance. This makes your annual net operating income $9,200. Now, following the above formula, simply divide the NOI by the total investment and you’ll get an 8.4% cap rate. This is your ROI.
#2. Out-of-Pocket Method (Cash on Cash Return)
The out-of-pocket method is used for calculating ROI in real estate on mortgage-financed transactions. It’s a bit more complicated because when you’re buying an investment property and financing it with a loan, you’ll need to account for the interest you pay each month in your expenses. How to calculate ROI on rental property that is financed with a loan? Just divide the annual return by the original out-of-pocket costs (total cash invested). Accordingly, the cash on cash return formula for using this method is as follows:
Let’s see what the ROI is for the same $100,000 house in the previous example when financed with a 30% down payment. In this case, your out-of-pocket expenses would include $30,000 for the down payment, $2,500 for closing costs (they’re higher for the mortgage), and the same $9,000 for remodeling. As a result, your total cash investment is $41,500. Now, to calculate annual return with mortgage payments in mind, take your net operating income and subtract annual mortgage payments. Assuming you have the same NOI of $9,200, let’s say your annual mortgage payments equal $4,000. In this case, the annual return is $5,200. Following the cash on cash return formula, this investment will give you a 12.5% ROI.
Use Mashvisor’s Property
Finder to find the best properties with high cash on cash return in your city
of choice! Sign up for free to get started.
What Is a Good ROI in Real Estate?
One of the most frequently asked real estate questions by first-time investors is “what is a good ROI for rental property?” Generally, the average return on investment is anything above 15%. However, seeing that there’s more than one method for calculating ROI as well as other complications, the more logical answer is – it depends.
On what exactly? There are numerous factors that influence the real estate return on investment and, hence, whether it’s a good one or not.
The first and most important factor is, unsurprisingly, the investment property’s location. We’ve all heard the golden rule in real estate investing: location, location, location. Where you buy a rental property will have a drastic impact on your potential profits. Rents will vary dramatically between rental markets across the US – and even between rental markets in the same state and city. Take California for example: according to Mashvisor’s real estate data, the traditional monthly rental income for Los Angeles rental properties is $3,324, whereas Sacramento rental properties generate $1,534 in traditional monthly rental income.
Another factor that affects what is a good ROI on investment property is whether the property was paid for in cash or financed via a mortgage. As you’ve seen from our previous examples, the potential profit you can expect from a property differs based on the financing method.
When it comes to cash transactions, experts say a good cap rate is anything from 4% to 10%. Keep in mind, however, that cap rates also vary by city: rental properties in Dallas and Austin, for example, have different cap rates.
As for mortgage-financed transactions, experts say anything from 8% to 12% is a good cash on cash return. However, remember that rental expenses and your total investment should be taken into account when estimating what is a good ROI in real estate. As a general rule, the less cash paid upfront as down payment, the larger the mortgage loan balance will be, but the greater your ROI in real estate. Conversely, when you borrow less, you should expect a lower return on investment since your total investment will be higher.
Therefore, in order to determine what is a good ROI on rental property, you need to perform ROI analysis and calculations using the different formulas before making an investment decision. ROI analysis also requires real estate investors to do a rental market analysis to study the location where they intend to buy, as well as rental property analysis to study the property itself and the costs associated with investing in it. While doing ROI analysis might seem like a dreadful task, it can actually be easily done if you’re using the right tool – the real estate ROI calculator!
What Is a Real Estate ROI Calculator?
Also known as the Investment Property ROI Calculator, it’s a tool that uses historical real estate data as well as predictive analytics to provide investors with the most accurate ROI calculations. Hence, this tool does the market and property analyses for you in a matter of minutes to help you make faster and smarter real estate investment decisions.
You can find an investor-friendly, easy to use real estate ROI calculator right here on Mashvisor! Here’s what our tool looks like:
As you can see, our Rental Property ROI Calculator is divided into three sections. The first is the Mortgage Calculator where you can plug in your financing details (down payment, loan amount, loan type, and the interest rate) if you were planning to finance a rental property with a mortgage. If, however, you plan to pay for the investment property fully in cash, you can simply select the cash option.
The next is the Expenses section where you’ll find the costs readily calculated for you. These include the one-time startup costs (like closing, inspection, and repair costs) as well as the recurring expenses that are expected to incur when investing in rental properties (like insurance, utilities, maintenance, property taxes, etc.) You can also choose to add an expense or modify the numbers as you like.
After plugging in your numbers, Mashvisor’s Investment Property ROI Calculator will automatically do the math and give you results in the Rental Strategy section. Here, you’ll get an analysis of what ROI you can expect in terms of the cap rate, cash on cash return, and cash flow based on the estimated comparable rental income. Not only that, but you’ll get to see the ROI on rental property as a traditional and an Airbnb rental and see which rental strategy will yield higher profits.
Another feature of our ROI Calculator is that it’ll give you a list of recent sales of similar properties and a list of comparable rental listings in the area where the property is located. These lists come with ready-to-use data as well. A real estate investor can use this for comparing the target investment property for sale with others to see if the expected ROI is truly a good one or not. In other words, you’ll find needed real estate comps to perform a market analysis without having to waste time searching for them on your own!
Needless to say, Mashvisor’s Investment Property ROI Calculator is the ultimate tool for investors to find and analyze profitable rental properties. Interested in giving it a try? Start out your 14-day free trial with Mashvisor now!
The Bottom Line
Figuring out ROI on rental property can be complex and there are many differences of opinion on what is a good ROI in real estate. Still, calculating ROI is key to determining if an investment property is worth pursuing and if you’re likely to turn a profit from real estate investing now and in the future. Hopefully, this complete guide for real estate investors gave you a full picture of ROI in real estate. If you have any questions, share them with us in the comments below!