Calculating ROI on a Rental Property

One of the major reasons people invest in property is to maximize their wealth. Some do it for retirement, while others are saving up for a rainy day—but money is almost always the root of a real estate investment.

The following is taken from Investopedia.com

A return on investment measures how much money or profit is made on an investment as a percentage of the cost of that investment. It shows how effectively and efficiently investment dollars are being used to generate profits. Knowing what your ROI allows investors to assess whether putting money into a particular investment is a wise choice or not.

The return on investment can be for any vehicle—stocks, bonds, a savings account, even a piece of real estate. Calculating a meaningful ROI for a residential property can be challenging because calculations can be easily manipulated—certain variables can be included or excluded in the calculation. It can become especially difficult when investors have the option of paying cash or taking out a mortgage on the property.

Here, we’ll review two examples for calculating ROI on a residential rental property—a cash purchase and one that’s financed with a mortgage.

To calculate the profit or gain on any investment, first take the total return on the investment and subtract the original cost of the investment. Since ROI is a profitability ratio, it gives us the profit on an investment represented in percentage terms.

To calculate the percentage return on investment, we take the net profit or net gain on the investment and divide it by the original cost.

The above equation seems easy enough to calculate, but keep in mind that there are a number of variables that come into play with real estate that can affect ROI numbers. These include repair and maintenance expenses, and methods of figuring leverage—the amount of money borrowed with interest to make the initial investment.

Calculating a property’s ROI is fairly straightforward if you buy a property with cash. Here’s an example of a rental property purchased with cash:

• You paid $100,000 in cash for the rental property.
• The closing costs were $1,000 and remodeling costs totaled $9,000, bringing your total investment to $110,000 for the property.
• You collected $1,000 in rent every month.

A year later:

• You earned $12,000 in rental income for those 12 months.
• Expenses including the water bill, property taxes, and insurance, totaled $2,400 for the year or $200 per month.
• Your annual return was $9,600 ($12,000 – $2,400).

To calculate the property’s ROI:

• Divide the annual return ($9,600) by the amount of the total investment or $110,000.
• ROI = $9,600 ÷ $110,000 = 0.087 or 8.7%.
• Your ROI was 8.7%.

Calculating the ROI on financed transactions is more involved.

For example, you purchased the same $100,000 rental property as above, but instead of paying cash, you took out a mortgage.

• The down payment needed for the mortgage was 20% of the purchase price or $20,000 ($100,000 sales price x 20%).
• Closing costs were higher, which is typical for a mortgage, totaling $2,500 up front.
• You paid $9,000 for remodeling.
• Your total out-of-pocket expenses were $31,500 ($20,000 + $2,500 + $9,000).

There are also ongoing costs with a mortgage:

• Let’s assume you took out a 30-year loan with a fixed 4% interest rate. On the borrowed $80,000 ($100,000 sales price minus the $20,000 down payment), the monthly principal and interest payment would be $381.93.
• We’ll add the same $200 a month to cover water, taxes, and insurance, making your total monthly payment $581.93.
• Rental income of $1,000 per month totals $12,000 for the year.
• Your monthly cash flow was of $418.07 monthly ($1,000 rent – $581.93 mortgage payment).

One year later:

• You earned $12,000 in total rental income for the year at $1,000 per month.
• Your annual return was $5,016.84 ($418.07 x 12 months).

To calculate the property’s ROI:Divide the annual return by your original out-of-pocket expenses (the down payment of $20,000, closing costs of $2,500 and remodeling for $9,000) to determine the ROI.

• ROI: $5,016.84 ÷ $31,500 = 0.159.
• Your ROI is 15.9%.

Some investors add the home’s equity into the equation. Equity is the market value of the property minus the total loan amount outstanding. Please keep in mind that home equity is not cash-in-hand. You would have to sell the property to access it.

To calculate the amount of equity in your home, review your mortgage amortization schedule to find out how much of your mortgage payments went toward paying down the principal of the loan. This builds up the equity in your home.

The equity amount can be added to the annual return. In our example, the amortization schedule for the loan showed that a total of $1,408.84 of principal was paid down during the first 12 months.

• The new annual return, including the equity portion, equals $6,425.68 ($5,016.84 annual income + $1,408.84 equity).
• ROI = $6,425.68 ÷ $31,500 = 0.20.
• Your ROI is 20%.

As mentioned above, knowing what the ROI is on any investment, especially real estate, allows investors to be more informed. Before you buy, you may be able to estimate your costs and expenses, as well as your rental income. This gives you a chance to compare it to other, similar properties. Once you’ve narrowed it down, you can then determine how much you’ll make. If, at any point, you realize your costs and expenses will exceed your ROI, you may have to make a decision about whether you want to ride it out and hope you’ll make a profit again, or whether you should sell your property so you don’t lose out.

Of course, there may be additional expenses involved in owning a rental property, such as repairs or maintenance costs, which would need to be included in the calculations ultimately affecting the ROI.

The ROI for a rental property is different because it depends on whether the property is financed via a mortgage or paid for in cash. As a general rule of thumb, the less cash paid upfront as a down payment on the property, the larger the mortgage loan balance will be, but the greater your ROI. Conversely, the more cash paid upfront and the less you borrow, the lower your ROI, since your initial cost would be higher. In other words, financing allows you to boost your ROI in the short-term since your initial costs are lower.