One of the main reasons people invest is to increase their wealth. Although the motivations may differ between investors—some may want money for retirement, others may choose to sock away money for other life events like having a baby or for a wedding—making money is usually the basis of all investments. And it doesn't matter where you put your money, whether it goes into the stock market, the bond market, or real estate.
Real estate is tangible property that's made up of land, and generally includes any structures or resources found on that land. Investment properties are one example of a real estate investment. People usually purchase investment properties with the intent of making money through rental income. Some people buy investment properties with the intent of selling them after a short time.
Regardless of the intention, for investors who diversify their investment portfolio with real estate, it's important to measure return on investment (ROI) to determine a property's profitability. Here's a quick look at ROI, how to calculate it for your rental property, and why it's important that you know a property's ROI before you make a real estate purchase.
Key Takeaways
- Return on investment (ROI) measures how much money, or profit, is made on an investment as a percentage of the cost of that investment.
- To calculatethe percentage ROI for a cash purchase, take the net profitor net gain on the investment and divide it by the original cost.
- If you have a mortgage, you'll need to factor in your downpayment and mortgage payment.
- Other variables can affect your ROI including repair and maintenance costs, as well as your regular expenses.
What Is Return on Investment (ROI)?
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 dollarsare being used to generate profits. Knowing ROI allows investors to assess whether putting money into a particular investment is a wise choice or not.
ROI can be used for any investment—stocks, bonds, a savings account, and 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 reviewtwoexamples for calculating ROI on residential rental property: a cash purchase and one that's financed with a mortgage.
The Formula for ROI
To calculate the profit or gainon any investment, first take thetotal return onthe investment and subtract the original cost of the investment.
To calculatethe percentage ROI, we take the net profit,or net gain, on the investment and divide it by the original cost:
ROI=CostofInvestmentGainonInvestment−CostofInvestment
For instance, if you buy ABC stock for $1,000 and sell it two years later for $1,600, the net profit is $600 ($1,600 – $1,000). ROI on the stock is 60% [$600 (net profit) ÷ $1,000 (cost) = 0.60].
Because ROI is a profitabilityratio,the result isoften representedin percentage terms.
Calculating ROI on Rental Properties
The above equation seems simple enough, but keep in mind that there are a number of variables that come into play withreal 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. Of course, financing termscan greatly affect the overall cost of the investment.
ROI for Cash Transactions
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 therental property.
- Theclosing costswere $1,000 and remodeling costs totaled$9,000, bringing your total investment to $110,000 for the property.
- You collected $1,000in rent every month.
A year later:
- You earned$12,000in 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.
- Yourannual returnwas$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 = 0.087or 8.7%.
- Your ROI was8.7%.
ROI for Financed Transactions
Calculating the ROI on financed transactions is more involved.
For example,assume you bought the same $100,000 rental property as above, but instead of paying cash, you tookout a mortgage.
- The downpayment needed for the mortgage was 20% of the purchaseprice, or$20,000($100,000 sales price x 20%).
- Closing costs were higher, which is typical for a mortgage, totaling $2,500 upfront.
- You paid $9,000 for remodeling.
- Your total out-of-pocket expenseswere$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, the monthly principal and interest payment would be $381.93.
- We’ll add the same $200per 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.
- Monthlycash flow is $418.07 ($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 returnby your original out-of-pocket expenses(the downpayment of $20,000, closing costs of $2,500, and remodeling for $9,000)to determine ROI.
- ROI = $5,016.84 ÷ $31,500 = 0.159.
- Your ROI is 15.9%.
Home Equity
Some investors add the home'sequity into the equation. Equity is the market value of the property minus the totalloan amount outstanding. Keep in mind that home equity is not cash-in-hand. You would need to sell the property to access it.
To calculatethe 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 forthe loan showedthat a total of $1,408.84 of principal waspaid 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 is20%.
The Importance of ROI for Real Estate
Knowing the ROI for any investment allows you to be a more informed investor. Before you buy, 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 that your costs and expenses will exceed your ROI, you may need to decide whether you want to ride it out and hope you'll make a profit again—or sell so you don't lose out.
Other Considerations
Of course, there may beadditional expenses involved in owninga rental property, such as repairs ormaintenance costs, which would needto be included in the calculations, ultimatelyaffecting theROI.
Also, we assumed that the property was rented out for all 12 months. In many cases, vacancies occur, particularly in between tenants, and you must account for the lack of income for those months in your calculations.
Real estate investors can diversify their portfolios while maintaining their ROI through pooled investments such as real estate investment trusts (REITs).
The Bottom Line
The ROI for a rental property is different than with other investments: It can vary greatly, depending 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 downpayment onthe property,the larger the mortgage loan balance will be, but the greater your ROI.
Conversely, the more cash paidupfrontand the less you borrow, the loweryour ROI,since your initial cost would behigher. In other words, financing allows you to boost your ROI in the short term, as your initial costs are lower.
It’s important to use aconsistentapproach when measuring the ROI for multiple properties.For example, if you include the home'sequity in evaluating one property, you should include the equity ofthe other propertieswhen calculating the ROI for your real estate portfolio. This can provide the most accurate view of your investment portfolio.
