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ROI On Rental Property
The intention to buy a rental home as an investor is to increase your passive income.
Regardless of the intention of the investors, it is crucial to know if the rental property you are buying is going to give you returns.
In this post, we will learn how to calculate ROI on rental property in detail.
What Is ROI On A Rental Property?
Rental return is a percentage that measures the profitability of your rental home based on how much it earns compared to maintenance costs.
Several factors can affect rental return, and total rentals such as total rental income, total operating cost, mortgage payments, and type of property.
It is advisable to calculate the return on investment on a rental property over the course of a year to better understand the property’s performance in terms of profitability.
It is essential to keep track of the property’s performance if you see a decline in the profit. The decline in profits could be due to charging less rent than the market or spending over the limit in the operating costs.
Return on investment can be used for any investment – savings account, bonds, stocks, and real estate.
Calculating an accurate ROI for rental real estate can be challenging because the calculations are easily influenced based on how many variables can be included or excluded from the calculation.
It can be even more complicated if investors have the option of taking out a mortgage or paying cash to purchase the rental property.
How To Calculate ROI on Rental Property?
The basic formula to calculate any return on investment is the same. First, you need to take the total amount of annual earnings and subtract it from the cost of the investment to get the net profit.
Then you divide the net profit by the total cost of investment to get the ROI.
ROI = Total Annual Earnings On The Investment – Total Cost Of Investment / Total Cost Of Investment
For example: If you purchase a stock of $2,000 and sell it after a year for $3,000. According to the ROI formula, your ROI would be:
ROI = 3000-2000/2000 = 1000/2000 = 0.5 or 50%
The above example may look easy and simple as it is for straight investment without adding any operational or maintenance costs.
To understand how to calculate ROI on the rental property, you need to determine how the rental property was acquired in the first place.
How to Calculate ROI on Rental Property In Case Of Mortgage Transaction?
For example, you purchased a rental property for $200,000, where you took out a mortgage.
- You made a down payment of 25% of the property value which equals $50,000.
- You also paid the closing costs to acquire a mortgage that totaled $3,500.
- You did some home repairs that cost you $5,000.
- Hence your total personal investment is (50000+3500+5000) $58,500.
Apart from your personal investment, there are going to be monthly expenses with the mortgage:
- Let’s say you acquired a 30-year fixed conventional loan at a 5.5% rate of interest. On the borrowed $150,000, the monthly principal and interest payment would be $851.68.
- Let’s say your monthly taxes and insurance combined are $350. Hence your total monthly payments including PITI is (851.68 + 350) $1,201.68
- Your rental property receives a monthly rent of $1,900 per month. This equals $22,800 per year.
- Hence your monthly net profit is (1900-1201.68) $698.32. This equals $8,379.84
After completion of one year:
- Total property gains were $22,800 (1900×12).
- Your annual net profit was $8,379.84.
To calculate the rental returns:
- Divide the annual net profit by your total personal investment to determine ROI.
- ROI = $8379.84 ÷ $58,500 = 0.143.
- Your return on investment on the property with a mortgage is 14.3%
How to Calculate ROI on Rental Property In Case Of Cash Transaction?
For example, you purchased the same property for $200,000, where you paid cash instead of taking a mortgage.
- You paid $200,000 to purchase the rental property.
- You did some home repairs that cost you $5,000.
- Hence your total personal investment is (200000+5000) $205,000.
- Let’s say your monthly taxes and insurance combined are $350.
- Your rental property receives a monthly rent of $1,900 per month.
- Hence your monthly net profit is (1900-350) $1,550. This equals $18,600
After completion of one year:
- Total property gains were $22,800 (1900×12).
- Your annual net profit was $18,600.
To calculate the rental returns:
- Divide the annual net profit by your total personal investment to determine ROI.
- ROI = $18,600 ÷ $205,000 = 0.090.
Your return on investment on the property with a mortgage is 9.07%
Conclusion
The intention of buying a rental property is to generate alternate income. Hence it is imperative that you know how to calculate real estate ROI on rental property.
A good ROI on a rental property is if the ROI is equal to or higher than 10%. The thing to note is that if your initial investment is less your ROI will be higher, however, if your initial investment is higher, your ROI will be less.
Since you now know how to calculate real estate ROI you can use it before you buy your next rental real estate, or you can use ROI calculators for real estate.
