Are you thinking of buying a rental property? Well, when you invest in a rental property, it is important to determine what the ROI will be. This can help determine how worthwhile your investment will be.
When you begin to invest in properties or start a property management company, you should familiarize yourself with some important calculations before you get started!
In this article, we will go over all the important questions that you need to ask before investing in a property, including the following:
- What is an ROI?
- How is an ROI calculated?
- What is the ideal ROI percentage?
- What is the 1% rule?
So, let’s talk about the importance of ROIs when it comes to purchasing a rental property!
What Exactly is an ROI?
An ROI refers to your return on investment. Your return on investment is the amount of profit that you will gain in return for the cash investment that you have made on a property. An ROI is typically expressed as a percentage of how much you paid for your investment.
For example, if you purchase a rental property for $200k and your ROI is 10%, you are making $20k in profit.
But why is your ROI important to know?
The purpose of this calculation is to provide you, the investor, with a clearer idea of whether your investment will be worthwhile or not.
After all, if your investment doesn’t make you a profit in the end, it may not be worth purchasing that property in the first place! Understanding this is an important aspect of accounting for your investment.
How Do You Calculate the ROI of a Rental Property?
When calculating the ROI of a rental property, there are three main methods:
1. Simple ROI Calculation
This is the most simple way to calculate the rate of return on an investment property:
ROI = (income from property – cost of property) / cost of property
For example, if you purchased a rental property for $100k, and the total profits generated from the property totaled $120k, the rate of return on your investment would be the following:
ROI = (120,000 – 100,000)/100,000 = 0.2 = 20%
As you can see, this formula is simple and relatively easy to calculate. While it is the easiest formula available to determine an ROI for a property, it is unfortunately not specific enough to offer a clear picture of the profit that would be made from the investment.
The other calculations on this list may be more difficult, but they will provide you with clearer and more specific results for your ROI.
2. Capitalization Rate
The capitalization rate, often referred to as the cap rate, is a helpful calculation that is commonly used by people who are planning on investing in real estate.
The cap rate can help you determine how profitable a rental property will be and allows you to compare multiple potential properties against each other to see which will generate the most profit.
Note that a cap rate may not be the most accurate method to determine the profitability of short-term rental property investment. This is because the value of a short-term rental property is often based on comparable properties in the area, rather than the income generated by the rental property itself.
A capitalization rate is most useful when it comes to determining the profitability of commercial rental properties.
So how do you calculate your cap rate? The cap rate represents the ratio between a rental property’s income and the amount that the property costs to purchase.
Step one in calculating your cap rate is to determine your net operating income.
Net operating income = rental income – operating expenses
Step two is to use the net operating income and the price of the investment to determine the cap rate. This can be calculated with the following formula:
Cap rate = net operating income / purchase price x 100%
Let’s say you purchase a rental property for $200k and spend $1,500 in closing costs and another $10k to remodel the home. The total of your investment would be $211,500.
Let’s say the cost of rent that you would charge your tenants would be $1,000 a month. This means that you will generate $12k of income annually.
To improve the realistic accuracy of your ROI, let’s deduct $2,000 from your total income to account for other expenses that often come with owning a rental property (tax deductions, maintenance, property management, insurance, etc.) This would make your annual income $10k.
To accurately calculate the ROI of your rental property investment, we must divide your annual income ($10,000) by the total amount that was invested into the rental property ($211,500).
Cap rate = (10,000 / 211,500) x 100% = 4.73%
Going by the above calculations, your total return on your investment would be 4.73%
3. Cash-on-Cash Return Calculation
While the cash-on-cash return method of calculation may be more complex than the previous ones listed, it is necessary for anyone who is using a mortgage or loan to cover the cost of purchasing an investment property.
As an example, let’s say you invested in a rental property that cost $200k. When you purchased this property, you put down a 20% deposit and took out a mortgage.
Your costs would be $40k for the down payment, in addition to paying $3,500 in closing costs and $10k in renovations for the property. The total amount of cash that you have invested in the property upfront adds up to $53,500.
However, when you use a mortgage or a loan to purchase any kind of property, you will need to pay interest each month. This should be considered in your overall calculations.
Take this example: your interest costs are $1,000, and the tenant that occupies your rental property pays you $1,500 for rent each month. This means that your cash flow will be $500/month. After one year, your return on your investment annually will be $6,000.
Using the cash-on-cash formula, we can determine the return of your investment by dividing your annual cash flow by the total amount of cash that you have invested in the property.
The formula should look like this:
Cash on cash return = (6,000 / 53,500) x 100% = 11.2%
The total will indicate the annual return that you will receive on your rental property investment.
What is the Ideal Rate of Return on a Rental Property?
The honest answer to this question is: it depends!
A reasonable or ideal rate of return is often subjective to the individual investor and their own set of circumstances or goals, in addition to the rental property’s circumstances.
For example, what is the location of the property? What are rental prices like in the area? Are there any risks associated with investing in this specific property?
The reality is, many different factors can contribute to whether or not an ROI is ideal for an investor or not.
That being said, a good return on investment is typically 15% or more. If you are using the cap rate method of calculation, an ideal return rate would be around 10%.
If you are using the cash-on-cash method to calculate your return, a good rate of return would sit around 8-12%. However, there are some investors that may not even consider purchasing a rental property unless their calculations predict a return rate of at least 20%.
At the end of the day, your metric for what a reasonable rate of return is depends on your own judgment as an investor.
The 1% Rule
You may have heard of the 1% rule, but what exactly is it?
The 1% rule is a general rule of thumb to help you determine how much you should pay for a rental property. This is useful for an investor that is considering hundreds of investment opportunities and does not have the time to deeply analyze each one.
The 1% rule can help you narrow down your options when it comes time to choosing the best investment.
The rule is that when you are looking for an investment property, you would ideally want to charge 1% of the total purchase value as monthly rent. For example, if you buy a rental property for $100k, you would want to use the 1% rule to ensure that you could charge tenants $1,000/month in rent.
While this rule isn’t foolproof, it is helpful when trying to narrow down a long list of investment properties to choose from!
Whether you’re looking for your first investment property or your hundredth, calculating the ROI of a property is the best way to determine whether or not your investment will be worthwhile.
We hope this article was helpful!