As an investor, one of the most important things for you to know is how to calculate ROI on rental properties.
There are many reasons why investors look to rental properties for building up their portfolios. For example, they can provide a great source of passive income that is recurring every month, property tends to increase in value as time passes, and there is a long list of tax benefits that property investors are privy to.
Though, while all these may all be wonderful reasons for investing in real estate, you never know just how well your investments are doing until you calculate the ROI on rental properties.
As a key metric, ROI can help you determine which rental properties perform better, which you should keep, which to let go, and so on. Let’s discover what ROI is, how it works, and how it can be calculated based on your specific scenario.
What is ROI?
Return on investment, or ROI for short, is a measurement of the profit made on an investment based on the original cost of that investment. The ROI is calculated as a percentage.
ROI can be calculated for many different types of investments – not just rental property. However, when it comes to things like gold or stocks, the return is always going to remain the same no matter where you are. In other words, the ROI of your stock portfolio will be the same whether you are in Phoenix, AZ or you are in Flagstaff, AZ. Rental property is an entirely different scenario.
To calculate ROI on rental properties, there are other outside factors to include, such as:
- What type of property it is (single-family, multi-family, short-term, commercial lease, etc.)
- Where it is located (current local market conditions)
- How much gross cash flow was earned
Property values can increase and decrease in each individual market – and those values will impact things like rent amounts, property values, and more. And each of these things will, in turn, impact your cash flow. This is why investors spend so much time analyzing their real estate investments before making the purchase so that they can make sure that they receive the greatest ROI.
Why ROI Matters
As a seasoned investor, you know that choosing the right piece of real estate to invest in as a rental property can yield you big earnings. Or, it could totally tank. Keeping an eye on your return can give you an idea of just how well you are doing – and how you are going to add to your future wealth.
How to Calculate ROI on Rental Properties
To calculate the ROI on rental properties, you will divide the profit you’ve earned by the cost of the investment.
Let’s look at a really simple example. If your earned profit is $20,000 and you have paid $20,000 for the initial investment, then you would divide your $20,000 profit by the $20,000 you invested and you get 1. Or, in percentage form, it would be 100%. In other words, that would show you have received a 100% return on your investment.
Now, let’s say your earned income was only $10,000.00 but you still invested $20,000.00 in the property. In this equation: 10,000 / 20,000, you would get 0.5 or 50%. This means you would have a 50% ROI on this property.
Keep in mind that these are very basic calculations. When it comes to rental properties, the equation is a little different. Let’s take a look.
Rental Property ROI Examples
Rental property ROI can be calculated this way: (Gain on investment – Cost of investment) / Cost of investment. Remember, there are a lot of factors at play in determining ROI for rental property. And whether you paid cash or financed the property will play a big role.
We are going to use the following example, both as cash and financed: You purchase a rental property for $100,000.00 in capital and it sold 5 years later for $135,000.00
– Cash Purchase ROI
Calculating ROI for a cash purchase would look like this:
Purchase price: $100,000
Sale price: $135,000
Mortgage interest or expense: $0.00
Rental income earned (gross): $6,000
First, you will determine your gain on investment. So, $6000 x 5 years is $30,000. Plus, you earned $35,000 on the sale, so that’s a total of $65,000. Then, you’ve earned your $100,000 back of your initial investment, for a total of $165,000.00 gain.
For the ROI, it would then look like this:
(165,000 – 100,000) / 100,000 = 10.53% annualized ROI and a total ROI of 65%
– Financed Purchase ROI
Calculating ROI for a financed purchase would look like this:
Purchase price: $100,000.00
Down payment: $25,000.00
Sale price: $135,000.00
Mortgage interest or expense: $3,804.00
Rental income earned (gross): $6,000.00 – $3804.00 = $2,196.00 (this includes the money earned minus interest/expenses)
Again, we will first have to calculate the gain on investments, which is $2,196 x 5 years is $10,980 + $35,000 you gained from the sale for a total of $45,980.00.
Then when calculating the ROI, it would look like this:
(45,980 – 25,000) / 25,000 = 12.96% annualized ROI and a total ROI of 83.92%.
Determining Your Investment Goal
There are many different factors that are involved in calculating the ROI on rental properties. Not to mention that there are also different formulas based on your type of investment or what you are trying to achieve. For instance, some investors are just interested in cash flow while others are more focused on the long-term appreciation of the property.
Knowing how to do the proper calculations means being able to fully understand whether you are meeting your investment goals. Teaming up with a financial professional is a great idea so that you fully can have an understanding of how to keep track of the health of your portfolio. Because each different focus requires the use of different calculations, knowing what you are looking to achieve is the first step in making sound decisions.