If you are interested in learning how to invest in real estate, you will hear the term return on investment (ROI) at every turn. When people buy a home to live in, sometimes emotions can get in the way, and they overpay for their “dream home.” When they live in the house, quality of life - rather than profit - usually becomes the most critical factor in determining success.
When it comes to rental properties, priorities shift. When you own a rental property, it is for the sole purpose of rental income and other financial returns. There’s no emotional attachment, only numbers. When you are thinking about buying a rental property, the numbers have to make sense before closing the deal. But how do you know if such numbers make sense?
Read on to learn about rental property ROI and how to calculate it before buying your first (or next) investment property.
What Are Rental Property Investments?
Successful real estate investors know how to invest in real estate for passive income. There are many ways to achieve this and many different types of properties you can buy. Investment properties can be either residential, commercial, or industrial - this all depends on their size.
Rental properties with five or fewer individual units are considered residential real estate. Some examples are single-family homes, condos, duplexes, and triplexes. Rental properties with more than five individual units are considered commercial real estate. Large apartment buildings are an example of this type of property.Whether you are renting out a single home or have a large apartment building investing portfolio, rental property investing can be a great source of income.
Why Are Rental Properties A Good Investment?
The residential real estate market is on fire. Home values are skyrocketing, with potential buyers getting into bidding wars and often paying way over the asking price. This means more and more people are getting priced out of the home buying process. So, they decide to rent instead.
Rental income is the lifeblood of a rental property. When a tenant leaves, the empty unit isn’t producing rental income until a new tenant is found. With expensive home-buying prices, many people are looking to rent these days, which makes filling a vacant unit easier than ever.
Properties are appreciating at a fast rate as well. That means if you buy a rental property now, it will be worth much more in three to five years. Not all rental properties are good investments, though. Careful consideration of the ROI is necessary before purchasing any rental property.
What Is ROI On A Rental Property?
The return on investment (ROI) for a rental property measures how much profit you make on the investment. ROI is the primary form of measuring success in all real estate investing, not just rental property investing.
Pretty simple, right? It can actually be a bit complicated because there are many different ways to measure ROI (more on that later). Rental properties can have a fantastic ROI in one type of calculation and a terrible ROI in another.
For example, some rental property ROI calculations will show you how much cash flow the property will provide each month. Others will define the predicted appreciation of the value of the property. That second metric is excellent for people looking to “buy and hold.” This approach involves purchasing properties, holding them for an extended period, and then selling them at a profit.
The ways to measure ROI are plentiful. Understanding how each one works is essential, and knowing which one fits your business goals is just as critical.
Define Your Goals
Before calculating rental property ROI, you need to decide which type of calculation means the most to you. Start by thinking about your short and long-term financial goals. Here are some questions you should ask yourself:
The critical decision you need to make is if you are more interested in monthly cash flow or appreciation. Cash flow represents how much money you bring after deducting your expenses. This is usually measured as monthly cash flow or annual cash flow. Appreciation refers to the value of the property increasing over time.
You may be wondering, “why can't I have both?” While that is possible, investment properties with excellent cash flow ROI and great appreciation ROI are rare. In most cases, you will need to prioritize one over the other. Regardless of which metric you prefer, understanding how to calculate rental property ROI will help you make an informed decision.
7 Ways To Calculate Rental Property ROI
There are many ways to calculate ROI for rental properties beyond the aforementioned cash flow and appreciation metrics. You can also measure net operating income, cash on cash, internal rate of return, and cap rate. In addition, there are several benefits to owning a rental property that can't be quantified using numbers. Read on as we dive into each of these concepts.
1. Net Operating Income
Net operating income (NOI) is calculated by subtracting your operating expenses from your rental property income and vacancy losses. This is similar to the cash flow calculation, but NOI does not factor in loan expenses. Cash flow does.
Your rental property income consists of rental income (the money your tenants pay to live in your property each month) and other income generated by the property. Additional income can include services you charge tenants for, like parking and snow removal.
Your operating expenses refer to everything you pay to keep your rental property business running. This includes things like maintenance expenses, paying employees, and property management fees.
Your vacancy losses refer to the lost rent from tenants who have left and no longer pay rent. Until another renter fills the unit they departed, you will take a loss each month.
Here's an example of how to calculate net operating income: Let’s say your monthly rental income is $5,000, your vacancy losses are $500, and your operating expenses are $1000. Your NOI would equal $5,000 minus $500 minus $1,000 for a total of $3,500.
NOI is an excellent metric for real estate investors comparing multiple properties because it shows them their possible returns without getting into the many details of their mortgage terms.
Appreciation refers to the increase in the value of your property. Recently, the real estate market has seen high appreciation rates throughout the country. This is true across all types of real estate, from single-family homes to high-rise office buildings and everything in between.
Real estate investors often view appreciation as a great way to build long-term wealth passively. Simply purchase a property and wait for the value to go up before selling it at a profit.
Appreciation is often seen as the “cherry on top” for investment properties. Other calculations are more important while you own the property (cash flow, NOI, etc.), while appreciation provides a nice lump sum of cash when it’s time to sell.
3. Cash Flow
Many real estate investors consider cash flow the single most important metric for investing success. To calculate your net cash flow, you simply take your monthly rental income (and other income) and subtract all of your expenses (like property management fees and mortgage payments).
Here is an example of how cash flow calculations work:
Total Expenses: $3,000
Monthly Cash Flow: $2,000 ($5,000 minus $2,000)
Annual Cash Flow: $24,000 ($2,000 x 12 months)
Cash flow is an especially valuable metric for making a cash purchase because it doesn't account for a monthly mortgage payment. Cash transactions can also help you get properties at a reduced purchase price because they appeal to sellers.
4. Cash On Cash
Another excellent gauge of rental property investments is cash on cash return. The calculation is determined by dividing your annual cash flow by your initial cash investment to purchase the property.
Here’s an example of a cash on cash calculation using the same numbers and incorporated costs for the down payment, closing, and improvements:
Measuring your cash return in relation to your initial cash investment appeals to many savvy investors. They view it as a more complete metric of success than other calculations. It’s also easy to compare to investing in stocks. For example, investing in long-term index funds has historically netted a return of about 7 percent.
5. Internal Rate Of Return
Internal rate of return (IRR) measures your ROI over a specific period. More specifically, it calculates your net cash flow combined with your expected appreciation, divided by a targeted amount of time.
This is a good metric if you are curious about how long you will need to own the property to get the amount of profit you want. The shorter the time you target, the more accurate it will be. After all, predicting appreciation and cash flow for the next three years is easier than predicting them for the next ten.
6. Cap Rate
Capitalization rate (cap rate) refers to the estimated rate of return on your rental property. It is like cash on cash but doesn’t include the purchase price. It also doesn't use your initial investment amount (down payment and closing costs). Instead, it uses the purchase price. Here's how to calculate cap rate.
Cap Rate + Net Operating Income x 12 months/purchase price
Purchase Price: $300,000
$3,500 (NOI) x 12 months = $42,000
Cap Rate: 14 percent ($42,000/$300,000)
7. Beyond The Numbers
Crunching the numbers is essential before making a sound real estate investment. That said, there are some intangible benefits as well. The experience you gain from purchasing and managing a rental property will benefit similar decisions in the future. Even if your first purchase isn't a slam dunk investment win, the lessons you learn will set you up for more successful investments in the future.
Rental property owners use a variety of metrics to calculate ROI. Each has its benefits and limitations. Think about your investment goals and decide which calculation means the most to you.