How to Calculate Return on Rental Property Investment
The first factor savvy real estate investors look at when deciding which rental property to invest in is the return on investment (ROI). This measures the profitability of an investment and indicates how lucrative it will be. So, it’s important that every property investor knows how to calculate ROI on rental property. This metric helps in analyzing investment properties to determine which one is optimal to make money in real estate investing.
Having said that, there are numerous formulas for calculating the return on investment, which often leave real estate investors wondering which one gives the most accurate estimations. Truth is, there is no “one-size-fits-all” in real estate investing, meaning you can’t say there’s only one formula for all property investors out there.
For example, you might be paying for an investment property with cash while another investor took out a mortgage. In this case, you can’t use the same formula because you can exclude the down payment, mortgage payments, and interest rate from the ROI calculation, but the other investor can’t or he/she will get false results.
In this blog post, we explain 3 methods of how to calculate ROI on rental property. Moreover, we’ll introduce you to an online calculator that analyzes investment properties and estimates their profitability in minutes.
How to Calculate ROI on Rental Property – The Simple Method
You might already know the simplest formula for ROI calculations, which states:
ROI = (Gain from Investment – Cost of Investment) / Cost of Investment
Say you purchase a rental property for $50,000 and the total profits you gained sum up to $80,000. Thus, your return on investment is 60%. While this is the simplest method of calculating the return on investment, it’s not always reliable. Smart real estate investors use two other methods, which are more accurate. Which method you should use depends on how you finance buying a rental property. These are the cost method and out-of-pocket method. Let’s have a closer look at them.
How to Calculate ROI on Rental Property – The Cost Method
Another name for this method is the cap rate approach, and it simply calculates ROI by dividing the net operating income by the cost of the investment property (Cap Rate = NOI/Purchase Price × 100%). As a real estate investor, you use the cost method when you finance buying the property fully in cash. Besides measuring the profitability of a certain property for real estate investing, this method is also used to compare similar investment properties.
Assume you bought a rental property with a purchase price of $100,000 in cash and you’re renting it out for $700 per month for an annual rental income of $8,400.
You had to pay $1,000 in closing costs and another $9,000 for remodelling, making your total investment in the rental property $110,000.
In addition, you have to deduct rental expenses when calculating the NOI. Say that every year you pay $1,000 for maintenance, $1,000 for property taxes, $500 for insurance, and $100 to advertise for new tenants. Deducting these rental expenses, your annual NOI will be $5,800, meaning your actual ROI is 5.2%.
As you can see, the cost method is a better way to calculate the ROI on a rental property. Still, property investors must remember to add ALL rental expenses that affect the net operating income and total investment costs in order to get accurate results.
How to Calculate ROI on Rental Property – The Out-of-Pocket Method
This is the most commonly used method, also known as the cash on cash return approach. This is how to calculate ROI on rental property when you’ve financed the investment with a mortgage. Thus, the formula for the out-of-pocket method is:
Cash on Cash Return = (NOI/Total Cash Investment) × 100%
Let’s go back to the $100,000 investment property mentioned above, but instead of buying fully with cash, you want to take out a mortgage loan. Typically, most mortgage lenders require you to put a 20% down payment. Assuming this is the case, your costs will include:
- $20,000 for the down payment ($100,000 purchase price x 20%)
- $2,500 for closing costs (they’re typically higher because of the mortgage)
- Same $9,000 for remodelling the property
Therefore, your total cash investment is ($20,000 + $2,500 + $9,000 = $31,500). Now it’s time to calculate your net operating income. After calculating your rental expenses, you’ll have to add the mortgage payments and interest rate to the equation. Assume that you’re left with a $3,600 net operating income. Following the cash on cash return formula, the return on investment for this property will equal 11.4%.
You’ll notice that we got a higher ROI when using the out-of-pocket method than what we got following the cost method even though it’s the same property. This does not mean the results are inaccurate! The difference is attributable to the mortgage loan which gives a real estate investor leverage to increase the return on investment.
At Reezy, we’ve created a calculator to estimate return on investment in real estate and compare it with other investment options. Check it out via the link – invest.reezy.ca