Everyone knows the importance of return on investment (ROI) – the popular and versatile tool for figuring out how your portfolio is performing. If you have a rental property, it is important to know how the ROI is calculated so you can determine its effectiveness as an investment.
Because ROI calculations can be easily manipulated – and certain variables can be either included or excluded in the calculation – getting a meaningful ROI can be challenging, especially if investors have the ability to pay cash or mortgage on the property. Here we look at two basic examples of how to calculate ROI on residential real estate.
A quick refresher
Return on investment is a measure used to estimate and evaluate the performance of an investment or to compare the performance of different investments. To calculate ROI, the net profit of an investment is divided by the amount of money invested and the results are expressed as a percentage or ratio.
For example, if you buy ABC stock for $1,000 and sell it two years later for $1,600, the net gain would be $600 ($1,600 to $1,000). The ROI on the stock would be 60% ($600 ÷ $1,000 = $0.60). (For more information, see: FYI On ROI: A Guide to Calculating Return on Investment .)
Cash transactions
If you buy a property outright, calculating its ROI is relatively simple. Assume you are paying cash for a rental property of $100, 000. You also pay $1, 000 in closing costs, plus $9, 000 for remodeling, making your total investment in the property $110, 000.
Fast forward one year. You collected $ 800 in rent each month, and thus harvested $ 9, 600 for the year. For the most realistic ROI, we subtract $167 per month from this cash flow (2.004 USD per year) to cover property taxes and insurance (two expenses you can't avoid). This gives you an annual return of $596.
To calculate the ROI of the property, divide the annual return ($7, 596) by the total investment you originally made ($110, 000). $ 7, 598 ÷ $ 110, 000 = 0. 069 or 6. 9%. Your ROI is 6. 9%.
Financed Transactions
Calculating ROI for funded transactions is a bit more complicated. Suppose you buy the same $100, 000 property as described above, but instead of paying cash, you take out a mortgage that makes a 20% down payment. Your costs are $20, 000 for down payment ($100, 000 sales price x 20%); $2, 500 for closing costs (they are higher because of the mortgage) and the same $9, 000 for remodeling. Your total expenses are $31, 500 ($20, 000 + $2, 500 + $9, 000).
There are also ongoing costs for the mortgage. Let's assume you took out a 30-year loan with a fixed interest rate of 4%.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 will add the same $167 per month to cover taxes and insurance, making your total monthly payment $548. 93. Note: A good tool for calculating the total cost of a mortgage is a mortgage calculator like the one below.
Now let's take rent into consideration. Assuming your tenant pays $800 each month, you will have a cash flow of $251. 07 monthly ($ 800 rent – $ 548. 93 mortgage payment). Fast forward one year again. Multiply that $251. 07 of 12 determines your annual net income, or return: $251. 07 x 12 = $ 3, 012. 84.
Next, divide the annual cash flow by your original outlays (down payment, closing costs and remodeling) to determine ROI. $ 3, 012. 84 ÷ $ 31, 500 = 0. 095. So your ROI is 9.5%.
Some investors add equity into the equation (keep in mind that equity is not cash you can spend; you would have to sell the property to actually access it). To get the amount of equity, review your mortgage amortization schedule to find out how much of your mortgage payments went toward paying off the principal (which builds equity). This is equity that can be added to the cash flow figure. In our example, the loan amortization schedule shows that $1, 408. 84 of the capital is paid out in the first 12 months. So, $ 4, 421. 68 ($ 3, 012. 84 annual income + $ 1, 408. 84 equity) ÷ $ 31, 500 = 0. 14. Result: an ROI of 14.
The Bottom Line
Of course, the above examples are pretty straightforward. They do not include any additional expenses that a rental property might cause, such as z. B. Repair / maintenance costs that would need to be included in the calculations – thus affecting the actual ROI. (For more information, see How to value a real estate investment property ).
Yet they show that the ROI changes depending on whether you are paying cash or financing the purchase of real estate. As a rule, the less money you invest in a real estate deal and the more you mortgage, the higher your ROI will be. Conversely, the more money you invest in a business and the less you borrow, the lower your ROI (but the greater your net income).
Regardless of the inputs you use to calculate ROI, it is important to use the same approach across all investments to get accurate comparisons. If you z. B. into account when valuing one property's equity, you should consider it when calculating the ROI for your other properties, if you have them, to get an accurate comparison.