The primary reason people buy or build real estate is for the return on investment (ROI). With real estate, investors can generate recurring income through rent and recoup more than they paid for the property after selling it, thanks to the appreciation in the home’s value. That said, most investors would still love to know what they could potentially earn either through rent or from a sale. After all, not every investment is profitable, so it’s always an excellent idea to calculate your ROI and weigh your options before you make your move.
On that note, this article will focus on how to calculate ROI on investment property. Let’s dive in.
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What Is Return on Investment?
ROI is basically how much money you earn from an investment. It’s a metric investors use to determine if an investment is a worthy venture or not. However, the ROI of real estate properties isn’t a static figure and depends on several variables, including property type, local market economics, and method of financing.
The latter is especially crucial because it determines the method investors will use to calculate their returns. In other words, there are different formulas for calculating ROI on cash and loan purchases. Quickly, let’s head straight into how to calculate ROI on investment properties financed through cash or a mortgage loan.
Calculating ROI for Cash Purchases
Usually, investors subtract the return on investment from the purchase price whenever they’re calculating profit. For percentage ROI, they divide the net gain on the acquisition by the cost.
However, in real estate, determining ROI isn’t that simple, and it depends primarily on whether you bought the property with cash or a mortgage loan. For cash purchases, you divide your annual income by the cost price of the home to get the percentage ROI.
For example, let’s assume the following:
- You bought a home with cash for $50,000
- Closing ($1500) and remodeling costs ($10,500) total $12,000, making the total investment sum $62,000
- You collected $1000 in rent every month for one year; as such, you have $12,000 as earnings at the end of the year
- Expenses, such as taxes and utilities, at the end of the year totaled $1800 ($150) per month
To get your annual income from these figures, you’ll subtract your earnings for the year from expenses: $12,000 – $1800 = $10,200.
Thus, your ROI would be: $10,200 ÷ $50,000 = 0.204 or 20 percent.
Calculating ROI for Financed Properties
Determining the ROI for properties purchased with a mortgage loan isn’t as straightforward as those bought with cash.
For example, let’s assume you bought the same rental property for $50,000 with a mortgage loan. The down payment is 30 percent of the cost price, which is $15,000. Typically, closing costs for mortgage-financed properties are higher, so let’s set that at $3000.
However, we’ll keep the remodeling cost at $10,500. Overall, your total expense for the purchase is $28,500.
Now, let’s also assume the bank gave you a 10-year loan with a 5 percent interest rate. On that note, your monthly principal and interest payment would be $680.33. If we add the monthly expenses of $150, you’ll have $830.33 as your monthly expenditure and $9,963.96 throughout 12 months.
If we subtract this sum from the $12000 yearly rent, your annual income will be $2,036.04.
To get the percentage ROI, you’ll have to divide your annual return ($2,036.04) by your total expenses ($28000), which will give you 0.072 or 7.2 percent OP.
What’s the ROI for Real Estate?
Most investors often ask, “what is a good ROI on investment property?” The answer to that question isn’t straightforward, as there’s no fixed ROI on real estate. That’s because ROI depends on a wide range of factors, including the size of the property and the investment risk.
However, the average ROI on rental property in the US is 8 percent, but you can generally aim for anything around 5 to 10 percent. That said, investors use several rules of thumb to ensure they get a good return on any investment deal. Some of these rules include:
– The One Percent Rule
This rule states that your monthly rent should be one percent of the cost of the property. It’s also called the cap rate. You could aim for a higher percentage, though, as that could ensure you get higher returns.
– The 50 Percent Rule
According to this rule, the total operating expenses for your home shouldn’t exceed 50 percent of your income. Of course, this figure doesn’t include payments for your mortgage loan. You could make your mortgage payments from the other 50 percent.
How Vital Is ROI in Real Estate Investments
Calculating the ROI of an investment helps you decide if the deal is a good one. The best investors don’t make any investment without counting the cost and figuring out what they’ll gain (or lose). Whatever they discover after their calculations will inform their decision.
Similarly, before buying a rental property, you should determine your expenses and income and use a rental property ROI calculator to calculate your earnings.
Of course, you could also use the methods in this how to calculate ROI on investment property blogpost to figure out your earnings. If you discover that the investment isn’t worth it, you can pull out quickly before you’ve made any commitments.
However, it’s good practice to consider more than one property while you’re on the market for real estate. This way, you can compare the ROI of each of them and determine which is a more worthwhile option.
Conclusion
Real estate investments are one of the sure-fire ways to rake in substantial income. However, no investment is without risk, and you could still lose money in the property market if you’re not careful.
As such, it’s good practice to carry out due diligence and count the costs before making any move. Be confident of the ROI before committing your finances to a rental property.
This article has provided comprehensive details on how to calculate ROI on investment property to help you make more informed decisions. We hope you’ll find our recommendations helpful.
You may also read: What is a 1031 Exchange in Real Estate: Rules & Process
