Real estate is widely considered to be one of the best and most consistent investments. However, calculating the value of your investments is more challenging than checking your monthly bank statement. many ways to Calculate your return on investment (ROI) for rental property Existence How you choose to do this depends on your situation.
In this article, we will discuss the importance of calculating ROI for real estate and then show you how and when to calculate ROI:
- cash flow
- cash-on-cash return
- capitalization rate (cap rate)
- Appreciation
Here’s how to calculate ROI on a rental property:
Why You Should Calculate ROI on Rental Property
Your ROI measures how efficient your investment is at generating returns. Historically, property values tend to rise faster than inflation. In addition, real estate investors can enjoy monthly cash flow from rental income and several tax benefits such as depreciation deductions and operating expenses. Other investments don’t have these propositions — at least not all at once.
However, determining your total ROI is easy if you need to consider the many benefits of real estate. To know how lucrative or cost-effective your investment is, you need to measure your ROI accurately.
That said, calculating ROI is not always a simple equation. Different real estate investors are looking for different things. Some investors are looking for their monthly or annual cash flow, others are more interested in the ROI of appreciation, and others need to learn. The difference. We’ll cover the basic equations for each of these and more.
cash flow
Your cash flow is how much is left over from your rental property each month after you pay your operating expenses and save money needed for repairs.
In other words:
Cash Flow = Total Monthly Rental Income – Total Expenses
Let’s assume that Jackie is trying to calculate her monthly cash flow. Here’s how she’d do it:
| monthly rental income | $1,600 |
| monthly mortgage payment | $625 |
| property taxes | $200 |
| homeowners insurance | $45 |
| Property management fee (10% of rental income) | $160 |
| Repair store budget (10% of rental income) | $160 |
| Vacancy Reserve Budget (5% of rental income) | $80 |
| Net monthly cash flow (or net operating income—NOI for short) | $320 |
According to experts, “good” cash flow is $100-$200 per monthly unit, so Jackie is making a good profit. However, what one real estate investor considers “good” may appear disappointing to another. If Jackie only makes $320/month on a $2 million property, it’s not a big deal to her. If the $320/month is for a $25,000 property, it’s a different story.
cash-on-cash return
While cash flow is one metric for measuring ROI, experienced investors will be more interested in the cash-on-cash return of their rental properties — and you’ll see why.
Your cash-on-cash return is the percentage of your investment’s net cash flow in one year. This equation is:
Cash-on-Cash Return = (Monthly Cash Flow * 12) / Initial Out-of-Pocket Cost
Let’s reuse the equation to determine Jackie’s net monthly cash flow:
Annual cash flow = $320 * 12
Annual cash flow = $3,840
Now, let’s calculate his total out-of-pocket expenses. The purchase price of Jackie’s rental property was $150,000. He paid a 20% down payment, or $30,000. She paid 2% in closing costs, another $3,000, and an additional $5,000 to cover renovation costs.
Overall, her initial out-of-pocket costs are: $38,000 (down payment + closing costs + renovations)
Now, we can calculate Jackie’s cash-on-cash return:
Cash-on-cash return = $3,840 / $38,000
Cash-on-cash return = 0.101 = 10.1%
Last year, Jackie made a 10.1% return on her initial investment.
Some real estate investors are happy with the 10.1% return, while others would suggest Jackie aims for closer to 12%. Real estate investors want to outperform the stock market, which has given an average of 6% and 7% returns over the past several decades. However, the compounded average annual growth rate of the S&P 500 over the past 30 years (excluding 2022) is 9.89% p.a.,
If you want to improve your annual cash-on-cash return, here are some simple things you can do:
raise the rent
Find out what the monthly rent people are paying for similar properties in your neighborhood. If Angela charges her tenants across the street $1,675, you probably can too. Before doing this, make sure you’ve given your current tenants plenty of notice. If they decide to vacate the property at the end of their lease, you’ll have more time to find new tenants without having to dig into your stockpile of vacancies.
With the additional $75/month, Jackie’s net monthly cash flow increases to $395. Then, his cash-on-cash return is:
Cash-on-cash return = ($395 * 12) / $38,000
Cash-on-cash return = 0.1247 = 12.47%
The extra $75/month adds an additional 2.37% to his cash-on-cash ROI.
refinance
If you’re not looking to raise the rent or your tenant still has nine months on their lease, you can also refinance your loan to lower your mortgage payment. If Jackie can reduce her payment to $75, she will enjoy the same cash-on-cash return as seen in the example above.
adjust your reservation
Jackie puts 5%, or $80, into her vacancy budget each month. However, Jackie’s tenant has lived there for five years, so she has saved $4,800 in her reserve budget. This is enough to cover three months of vacancies. Instead of continuing to add to her reserves, she could eliminate that budget line item and bring her net monthly cash flow down to $400. This would take his overall cash-on-cash return to 12.63%.
If Jackie put a pretty penny into her repair store budget, she can adjust it instead and get a higher cash-on-cash return.
cap rate
The cap rate formula is perfect for deciding which property to buy. Your cap rate is the expected rate of return for your investment, based on how much you will generate in income.
Here’s the cap rate formula:
Cap Rate = Annual Net Operating Income / Purchase Price
Remember, your NOI is your income-expense.
Cap rates aim to achieve the highest possible percentage. The higher the percentage, the faster you’ll get the ROI.
Calculating the cap rate of a property is important because:
- You can compare investment propertiesCap Rate: If you’re stuck between two different investment properties, use the cap rate formula to determine which one will have a higher ROI. This is the property you should buy.
- You can determine the profitability of an assetCap rate: Compares the income you are getting with what you are paying for the property.
- It helps you estimate your payback period: Your cap rate percentage will indicate how long it will take for your investment to pay off. If your cap rate is 10%, this will take you ten years. If it’s 5%, it will take you 20.
Jackie is divided between two properties:
- property 1 Has a market value of $500,000, annual income of $75,000 and annual expenses of $40,000.
- property 2 Has a market value of $600,000, annual income of $85,000 and annual expenses of $45,000.
cap rate for property 1,
Cap Rate = ($75,000 – $40,000) / $500,000
Cap Rate = 0.07 or 7%
cap rate for property 2,
Cap Rate = ($85,000 – $45,000) / $600,000
Cap Rate = 0.667 or 6.67%
Based on the cap rate formula, Jackie should buy Property 1.
However, before she buys, there’s one more thing to consider: These calculations are based on the current market, rental income and operating expenses of the property. If Jackie renovates the property and increases its value by $100,000, then charges more in rent, the cap rate equation will change. For this reason, you should also calculate the after-repair value (ARV) of the property, the cost of renovations, and what you will charge tenants. Then, compare this to current cap rate calculations.
If you want to see the cap rate on steroids, read about how it’s calculated internal rate of return (IRR),
Appreciation
Last but not the least is appreciation, which is an increase in the value of your property. Calculate your appreciation if you want to buy and hold your rental property.
Let’s say Jackie bought her rental property in October 2007 for $150,000 and is selling it in October 2022 for $450,000; and wants to know the rate of increase in the value of her house. Here’s how she was able to find it:
A = p * (1 + r/100) n
- A = Appreciated Value
- p = purchase price
- r = rate of appreciation
- n = number of years since purchase
400,000 = 150,000 * (1 + R/100) 15
Jackie’s home price appreciation rate is 7.60% per annum.
Unfortunately, Jackie had yet to learn that, in 2007, her rental property would be worth three times its market value in 2022. In an alternate reality, he may only be worth $200,000, not $450,000.
For appreciation to work in your favor, follow the classic real estate mantra, “Buy low, sell high.”
While we can’t predict the future, upcoming cities and neighborhoods with many of the following characteristics are more likely to have high appreciation rates:
- job growth
- population growth
- high occupancy rate
- diversified economy
- higher wages
- EXCELLENT LIFESTYLE AMENITIES
- infrastructure development
Calculating ROI on Rental Property
Which equation you choose to use depends on your circumstances:
- Use the cap rate formula to determine which property you want to buy, but remember to include the ARV, rent increase and renovation costs in your calculations.
- Use the cash-on-cash return formula to determine your annual ROI and compare it to how other investments are doing. Adjust your cash flow spreadsheet to improve your net operating income to enjoy better returns.
- If you’re considering buying and holding for the long term, use the appreciation formula to determine how much your rental property is going to increase in value each year.
For more information, read about both biggest mistakes Dive deeper into rental property return calculations, and into cap rates. Also check out our forum get answer For any real estate questions you may have.
Play your numbers like a pro!
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Note by BiggerPockets: These are the views expressed by the author and do not necessarily represent the views of BigPockets.
