When entering the lucrative world of rental properties, it’s crucial that you learn how to calculate your ROI. This is critical in comprehending how to assess the true value of your rental properties. By learning how to calculate your ROI, you’ll be able to account for each and every expense involved in operating your rental properties, which prevents you from losing money on these investments.
In fact, estimating the ROI of a rental property can help you determine whether or not you even want to invest in it in the first place. It also assists you when it comes to knowing which rental property to commit to. There might be a lovely 2 story brownstone in the city, but would it be more advantageous to invest your capital in the single family home outside of town? By knowing the various methods to calculate your ROI, you’ll be able to select the rental properties which will produce the highest yield.
Monthly Operating Expenses
How to Calculate an ROI
ROI stands for “Return On Investment”, and means just what it states: how much you will earn on an investment, or your profits gained from an investment. The ROI is a well favored tool when it comes to finding out which rental properties will be the most profitable, and is always expressed as a ratio or percentage. While calculating a ROI is generally simple, it’s a bit more complex with regards to rental properties. First off, the basic formula is easy to comprehend:
Dollar amount of the return / Investment cost = ROI
While it seems a basic mathematical calculation, when it comes to rental properties other factors have to be considered. These factors may include maintenance costs, amount of down payment, as well as interest rate. So lets take a look, to see how to figure in the variables. Say you want to purchase a home with the purpose of renting it out. You find a lovely $130,000 home, and fix it up. After all the standard expenses, including maintenance, remodeling and repair, you’ve spent $12,000. This means my total, out of pocket expense for the property is $142,000. I’m now ready to rent it out. I find a nice couple who agree to pay $1,500 per month. I now need to calculate my annual ROI.
- 1,500 x 12 = 18,000, this is our annual return from rental payments
- Divide 18,000 by $142,000 which gives us 12.6 percent
- ROI = 12.6 percent
If this is your first time out, you may become a bit confused when it comes to ROI. This is because with rental properties, there are different formulas which can be used to calculate your return on investment. So, which one should you choose? Which one will give you the most accurate percentage to you can gage which is you most lucrative property? Unfortunately, there is no one right answer, there is no one formula that will handle all rental property situations.
If all of this has you a bit befuddled, have no fear. We’ll take you through the process, step by step. Not only that, we’ll also introduce you to a handy, professionally designed ROI rental property calculator, that is just what you need to quickly assess the ROI of your various rental properties.
Method One – The 1% + 2% Rules
You’ve more than likely heard of both of these rules at this point as they are a very popular method for quickly analyzing a properties potential profitability as a rental property among investors. While definitely not the most accurate formula you can use, it’s a great tool for quickly narrowing down potential investment properties.
The 1% rule states that in order for a rental property to be a “good” investment, the properties monthly rental income should be equal to 1% of the properties initial purchase price.
For Example: A $150,000 home should be bringing in a minimum of 1,500.00 per month in rental income.
The 2% rule is the exact same formula, simply adjusting for a much higher minimum ROI at 2% monthly rent of the purchase price. (3,000.00 per month in the example listed above). No matter which rule you use, It’s important to remember that there are many, many variables that go into purchasing a rental property you have to consider beyond just the expected rental income!
Method Two – NOI / Purchase price
The second method is referred to as the “Cap Rate” method. Cap rate stands for capitalization rate, and is used when you are using cash to finance a rental property. Cap rate calculations are used by real estate investors to estimate the possible return on their investment, so it’s critical to be as detailed as possible when collecting your numbers. Leave no stone unturned when it comes to your operating costs, even if you needed to call out a local handyman to fix a clogged drain for $50.00, add that into your operating costs. Being as strict and detailed as possible guarantees you the most accurate result. Note that these numbers represent operating costs only, not your mortgage payments. In this calculation, you are dividing the NOI, or Net Operating Income, by the original cost, or purchase price of the property.
For example, say we purchased our hypothetical rental home for $130,000 in cash, and are renting it out for $1,500 a month, which gives us $18,000 annual rental income. While the home costs $130,000 in cash, we also had to pay $1,200 in closing costs, plus needed to remodel the kitchen for $8,000. This means we actually spent $139,200 for our rental property.
Since this is a rental property, you will have expenses. This means you have to deduct these expenses in order to calculate your NOI. Lets say that in the past year we needed a hot water tank replaced, as well as a new window installed in the kitchen, which cost us $1000 total. As for property taxes, it’s $1,200, $750 for homeowners insurance.
- Actual Property Cost: $139,200
- Annual rental income: $18,000
- Property management: $500
- Repairs/maintenance: $1,000
- Property taxes: $1,200
- Homeowners insurance: $750
- Total Expenses: $3,450
- NOI: $18,000 – $3,450 = $14,450
ROI: $18,000 – $3,450 / $139,200 = 10.4 percent
Now, take this total and subtract it from your annual rental income. This is your NOI. Finally, divide it by the purchase price.
Lowering NOI by Lowering Operating Costs and the Vacancy Buffer
As you can see by the above example, your operating costs can take a huge chunk out of your profitability. Once you use ROI calculations to crunch your numbers, you’ll note the real costs involved, which highlights the importance of reducing your net operating income. By doing so, you encourage a healthier cash flow. Ways to decrease your NOI include weatherizing your property to save on energy costs, shopping around for the best price with regards to maintenance and repairs, and using Energy Star Certified appliances.
Also, take a look at becoming LEED certified. LEED stands for Leadership in Energy and Environmental Design. LEED certification will mean you’ll be saving on energy costs, which automatically lower your properties operating costs. Not only that, LEED can also help attract dependable, eco-friendly tenants to your property. LEED certification covers water efficiency, energy efficiency, CO2 emission reductions and indoor environmental air quality.
In order to safeguard yourself from possible vacancies which can occur during the year, include a vacancy buffer into your calculation. Here, you select a percentage to represent your vacancy rate, for our example, we’ll use 10 percent. This then takes our monthly $1,200 income rate down to $1,080. This is known as a vacancy buffer. While not all real estate investors include it in their calculations, it’s recommended that you should, since rental properties can remain vacant for several weeks at a time during the year.
Real Estate Trends And ROI
The first consideration is the location of the property. When you’re considering purchasing a rental property, remember that location counts. The cap rate of a rental property in San Francisco or Manhattan will be much more lucrative than one in the backwoods of Montana. Location refers to the MSA, or Metropolitan Statistical Area where it’s in, as well as where inside the MSA the property sits. MSA represents the geographical location of a property which is situated in a highly populated area, as opposed to a rural, loosely populated area. There are currently 383 MSA’s recognized in the U.S., and Miami is one of them. So, by taking a look at the current trends in Miami, plus doing calculations on properties that spike your interest, you’d definitely get a clearer picture of how to invest your capital. For instance, in 2018, the cap rates for multi-family units ranged from 4.62 to 6.45:
New Luxury Metro: 4.62 percent
A Class: 5.14 percent
B Class: 5.67 percent
C Class 6.45 percent
Value Added Acquisition 6.34 percent.
Trends in Miami that affect cap rates included a strong economy, stable rents and a vacancy rating of less than 5 percent. By knowing your math, and then doing research with regards to an areas trends, it’s easy to see that Miami may be a good place to invest, due to an increased demand for rental properties. Before we go, know that using this calculation to determine your cap rate is not useful if your business is flipping real estate, because the income you’ll receive is not from rental payments.
Method Three – Cash on cash return
Annual Rent – Mortgage/Total Cash Investment) x 100 percent
This third method is referred to as the cash on cash return method or equity dividend rate, where cash flow equals annual rent minus mortgage. Out of the three formulas mentioned, this is the most used, as it incorporates the mortgage. If we take our $130,000 rental home, and instead of plunking down the total in cash, we take out a mortgage, we’d use this formula. The numbers will be a bit different as we’ll have to include our down payment, and increased closing costs. First, consider that we’d have to put 20 percent down payment on the home. So our costs are $26,000 for the down payment, $2,000 closing costs, plus the $8,000 to remodel the kitchen:
- Down payment: $26,000
- Closing costs: $2,000
- Kitchen remodel: $8,000
- Total cash investment is = $36,000
- Annual cash flow: $5,000
$5,000 / $36,000 = 13.8 percent
Notice that our percentages for both the cash on cash return and cap rate are different. This difference does not indicate inaccuracies, it simply points out the different between purchasing the property with cash and taking out a mortgage.
Frequently Asked Questions Regarding ROI
What does the ROI do?
The ROI is also known as the cap rate, or capitalization rate. Here, you use formulas to calculate the average annual rent that your property will bring in. This number is represents a percentage of purchase costs. Once you have a good idea on the cap rate, you can then do some research into the area where your property lies. The reason for this, is that you want to find out what that locations median cap rate is, and compare it with your own numbers. This tells you whether or not you’ve found a profitable deal or should continue looking elsewhere.
Using an Online Calculator
Now that you have an idea of what the numbers mean, we can talk about the benefits of using an online ROI rental property calculator. By using this calculator, you’ll obtain the most accurate results possible, as you won’t have to be concerned about errors in manual computation, or setting up a spreadsheet. This handy investment tool is essential for real estate investors looking for a good ROI.
Where can I find information on cap rates?
In order to analyze rental trends on the local level, you’ll need to find the data. There are several top of the line websites which can help give you a good idea of cap rates. These include:
- National Association of Realtors
Do I Need to Take a Business Math Course or Know Accounting to Understand ROI?
No, not at all. These are basic mathematical formulas where you simply divide your investment earnings by the investment cost. This can be done manually or with a ROI rental property calculator.
In order to get the most out of the ROI, is statistics necessary?
No, for making basic calculations, a knowledge of statistics are not necessary. There are actually plenty of places online that report on annual rental property investment trends, so you won’t have to be concerned with that.
What are the One Percent and 50 Percent Rules and can they be used to replace ROI formulas?
No, they are entirely different and should not be used to replace your ROI calculations. The 1% or 2% percent rule is used when considering rental properties. Here, you want the gross monthly rental income to be 1 percent of the property cost. For instance, if our house $130,000 rental house would not be able to fetch at least $1,300 a month, then it’s not considered a good investment property. This means that the monthly rent will be equal to or more than the mortgage payment.
The 50 percent rule states that the overall, total cost of a rental property, not counting mortgage or interest payments, should be 50 percent of the gross rent. While both of these rules are part of the set of tools investors use, they are just that: Tools. When you deal with investment properties, other factors such as location, vacancy rates, maintenance and other expenses fall into play, that is why the ROI calculations are a much better indicator.
I’m a beginner in the game, so what should I look for regarding rental properties?
This is a pretty big question, so we’ll keep it simple. You need to be concerned with finding a rental property that will produce a high yield, give you a nice capital gain and rental return. Also, don’t forget the expenses. Look for a rental property that won’t burn your budget. In other words, look for low maintenance properties which won’t require too much in the way of renovation or future maintenance. Once you find these properties, you can use the ROI rental property formulas above to get a good estimate on the returns.
What is Capital Gain?
Even if you are looking at this rental property as a long term investment, there may come a time you wish to sell. In that case, you want your property to generate a healthy capital gain when you unload it.
Which formula is more accurate in assessing properties, gross yield, net yield or ROI?
This refers to the money you receive from your tenants. This is the rental income your property generates in one year and shown as a percentage of the original purchase price. Gross yield is the amount before expenses, and net yield is the amount after expenses.
Gross Yield: Annual rent / Original purchase price
Net Yield: (Annual rent – expenses) / Original purchase price
ROI: (annual rent – expenses / Actual cash invested
Of the three, the ROI is the most accurate. This is due to the fact that the ROI takes into account the expenses and the cash you’ve put into the property. Whereas gross and net yield only take into account the original purchase price. So, if you’ve many rental properties on your plate to consider, then doing a quick gross yield computation may help you weed out the unproductive ones, while a ROI computation can help you get a more accurate reading of just how your cash will be utilized in the property.
In summary, the calculation of ROI is not as difficult as one would think. Simply calculate your annual rental income, subtract the expenses, add any equity and divide by the total investment. Always remember that these numbers are not to be used as the sole determinant as to whether you should purchase a property or not. You need to analyze trends as well, examine the location, and whether you plan on paying cash or taking out a mortgage. In fact, the nature of calculating the ROI is so dynamic, that no two real estate investors will come up with the same percentage. This is due to the differing variables each investor considers important. Some may add in HOA fees, another may not. One may include management fees while another may not, and so on.