How to Calculate Your ROI in Real Estate Investments
You are looking to close an excellent investment property deal.
One of your friends asks what is the ROI on the rental property.
Suddenly you realize you cannot provide a concrete answer because there are several answers. Is your friend asking about the cash-on-cash return, capitalization rate, internal rate of return, appreciation, or cash flow?
For the real estate investor, few things are more important than a good ROI. After all, the basis of any investment is to make money and grow wealth.
If you can get an accurate figure of potential profits from a rental property before acquiring it, you are more likely to succeed.
So, keep reading this complete guide on what is and how to calculate real estate ROI.
What is a Return on Investment (ROI)?
A ROI is the ratio between the cost of an investment and the profits. ROI is a measure of the money you make as a percentage or ratio of the total investment cost in a rental property. Use the ROI to test a property’s profitability or even compare the profitability of unique properties.
Fortunately, you need not be a math genius to learn this critical numerical concept when it comes to real estate investments.
So, how do you calculate real estate profitability?
Learning how to calculate the ratio requires understanding the various variables that you can include or exclude for an accurate figure.
Calculating Your ROI
The ROI formula is easy to understand and simple to follow. Based on the ROI definition above, the formula is:
ROI = (Gain from your investment minus Cost of your investment) divided by Cost of your investment
Gain from your investment is an estimate of the amount you can expect over a year in terms of rent, which is the monthly rent multiplied by 12 months.
The cost of your investment is the sum of all expenses incurred within the year, including maintenance and mortgage payments. Once you subtract the figure of gain from the investment, you end up with the cash flow.
The formula provides a simple rate of ROI. However, you can also calculate the ROI using other formulas, depending on the method you are using to pay for a rental property.
ROI for Cash Transactions
The capitalization rate (cap rate) is suitable if you are paying for the property fully in cash. While it is a good profitability measure of investment properties, this formula is usually used to compare similar properties.
The cap rate is the ratio between the property Net Operating Income (NOI) and the purchase price.
NOI = Total rental income minus Operating expenses
Cap Rate = NOI divided by Property purchase price multiplied by 100%
ROI for Financed Transactions
Cash-on-Cash (CoC) is ideal for the investor who is taking a loan or mortgage to pay for her real estate investment.
The formula is:
CoC = (Annual cash flow divided by Total investment) multiplied by 100%
Therefore, CoC is the ratio of the property annual NOI and the amount of cash you actually invest in the property.
Difficulties in Calculating the ROI
Unfortunately, calculating a correct ROI figure may not be as easy as it seems.
As you learn how to work out rental returns, you will also discover difficulties in reporting investments along the way.
Misrepresentation of investments and profits
It is easy to misrepresent your investment in the ROI formula.
For instance, the ROI might be inflated because it does not include expenses like transaction fees. Failure to include the charges can easily skew your data.
Further, many real estate investments have skewed ROIs. This is usually because sellers ignore the finer details like insurance and property taxes.
A major weakness in calculating ROI is that its definition is so open ended, which makes misrepresentation easy. Without realizing it, you can also leave out some critical expenses, leading to wrong information.
Comparing ROI
Comparing ROIs leads to another major complication. While ROI shows the success of an investment, it does not offer the full picture.
For example, a property can have a high ROI and a $100 return, while another one provides a low ROI but a $10,000 return. It’s clear what of the two properties makes a better investment for any investor. If you are looking at the ROI alone, you are not getting a full idea of what that property is about.
Time ignored
During a ROI calculation, you may also be ignoring time, which can make a rental property that looks promising a waste of time.
For instance:
Property A has a 50 percent ROI, which is great on paper but could take 15 years to achieve.
VS.
Property B has an ROI of 15 percent that you can pay off within 12 months.
Which is a better choice?
Financing terms
The financing option you choose to acquire property has a great impact on the overall cost of your investment.
Calculating ROI becomes complicated when you opt to refinance or take a second mortgage. The interest rates on the subsequent loan are likely higher, and you likewise incur loan fees—both of which will reduce a ROI rate.
If you buy a property using an adjustable-rate mortgage (ARM), your calculations may become even more complex.
Length of a mortgage loan
Taking a 15-year instead of a 30-year loan, for example, helps increase the annual ROI you get from the property. Paying over 20 percent down decreases your ROI, no matter whether you opted for the 15- or 30-year mortgage loan.
Fluctuating costs
Remember that you will also likely have higher property taxes, maintenance costs, and utility rates. If you are paying all the expenses, then you need to incorporate these digits into your ROI.
All complications aside, calculating ROI is still a critical process for any rental property investor.
Why is it Important to Calculate the ROI?
Calculating the ROI of rental properties provides you with several advantages.
A measure of property profitability
It helps you identify the net income coming from your investments. Knowing how to figure out the ROI for a single family rental or a complex is a critical tool for your real estate business.
Investors know their performance is based on how they are using their assets to earn a profit, which is the push you need to optimize the use of the rental. Additionally, you can assure that the property you are looking at is going to give you returns in accordance to your requirements.
Helps you achieve your goals
The ROI ratio or percentage ensures that you are keeping to your investment goals. An increase helps improve the overall ROI of your rental investment portfolio.
Helps analyze units
Learning how to calculate real estate ROI is a skill you need to compare different rental properties in terms of profitability. You can use the figure to size up properties in different states, especially if they are the same size and located in similar types of neighborhoods. Use ROI to compare how much money you need to invest in each property to ensure maximum profitability.
Match with accounting measurements
ROI is a financial accounting measurement that is accepted in traditional accounting.
You don’t have to create a new accounting measurement to get the information you use while calculating ROI. All numbers within the formula are easily available in financial statements in a conventional accounting system. While it might require some adjustments, this is not a big issue when it comes to calculating the ROI.
Using a Cash Flow Calculator
Are you looking to buy a new rental property? Or, do you simply want to check how your current unit is performing in the market?
A rental cash flow calculator is a nifty tool that helps you measure success. If you are looking for a fast way to keep your eyes on the prize, the calculator does the trick.
The calculator accounts for all your up-front investments and ongoing costs. The calculation includes all the provisions for adding costs like electricity, cable, pest control, Home Owners’ Association (HOA) fees, and insurance. Further, you also get to include vacancy rates, property management fees, and repairs so that you have an accurate picture of what’s going on in the actual world.
Just enter your numbers and see what happens.
Different real estate investors have competing opinions on what is a good ROI on a rental property. The average “good” ROI for investment is above 15 percent. Whether you are using a CoC calculation or a mortgage calculation, using an online calculator is a valuable measurement tool.
With the help of the calculator, you can make an informed decision on whether a prospective property is worth a second look!
Conclusion
It does not take much time to calculate the ROI of a property that interests you. This is one of the most straightforward yet critical calculations you will ever make. And you need not have a math degree or be an accounting superstar to find out if the rental property is a profitable investment!
Now that you know how to calculate the real estate ROI ratio or percentage, you can finally tell everyone you know that your purchase has a great financial future. Start making better real estate purchasing decisions today by using a ROI calculator!
