Rental Property ROI: Real Estate Investing
About the author: Sarah Li-Cain is a finance writer and Accredited Financial Counselor candidate whose work has appeared in places like Bankrate, Business Insider, Redbook, Financial Planning Association and Kiplinger. She’s also the host of Beyond The Dollar, a podcast where she and her guests have deep and honest conversations on how money affects your well-being.
Calculating ROI on a rental property
Having a good understanding of how to calculate ROI on real estate investment property can make or break your real estate investment venture. Seriously.
Of course, you want to make sure whether your rental property is a good investment or has the potential to turn into a money pit. Sure, the rental market can fluctuate so calculating ROI will help you better predict whether you’ll be able to succeed.
When you’re evaluating a rental property, here’s what you need to know about calculating its ROI so you can have a better idea about the true potential of your future investment.
What is ROI for rental properties?
ROI is short for return on investment—how much money or profit you’ll make on your investment. It’s typically expressed as a percentage over the cost of your investment (in this case, your rental property) and can reveal to you how effective or efficient your investment dollars are being put to good use.
The challenge with calculating ROI for rental properties is interesting because people can easily manipulate them. For instance, you can include or exclude certain variables in the calculation. Plus, the number also depends on whether you’re financing, like with a hard loan, or paying in cash for the property. That’s why it’s important to understand some of the factors that affect property ROI.
How to calculate ROI on a rental property
Calculating ROI on a rental property can be broken down into these four steps:
- Calculate your annual rental income
- Figure out your cash flow
- Calculate your net income
- Get the ROI by dividing your net income by your total upfront investment
Gather the right numbers
Before calculating your ROI, make sure to consider your upfront expenses in addition to recurring expenses. Initial investments typically include your closing costs, down payment, interest rate, and any repairs or renovations to get your property to be move-in ready.
Then you’ll want to look at your ongoing expenses so that you can compare them against your rental income. Some of these expenses include property maintenance, taxes, and homeowners association (HOA) fees.
This is the part where people are tempted to underestimate their numbers. Sure, you want to minimize costs and assume you don’t need to set aside as much money for ongoing expenses, but vacancies happen. During this time you still have to pay for them, whether or not you have income.
Most experts recommend setting aside
- a conservative estimate of 10% of your monthly rental income towards expenses related to vacancy such as marketing and lost rent.
- around 5% for repair and maintenance expenses for a newly rehabbed unit or up to 25% for older or less well-kept properties.
Again, make sure to calculate the "real" numbers. This means getting clear on how much you might pay in property taxes, HOA fees, and insurance (call for estimates if you have to). Do the legwork yourself even if the seller or agent offers you numbers.
Then it’s time to calculate how much you can bring in—setting the monthly rental price (your gain on the investment). Sure, you can set it based on your own expenses, but you want to price it so that it’s competitive with what other properties are renting for. That also includes looking at the rental market and seeing what the demand is out there.
Otherwise, if the property you wish to buy is already being rented out, use that figure instead.
So now that you have the numbers ready, it’s time to calculate your potential ROI.
Here’s the basic formula: ROI = (annual return/net gain [gain on investment – cost of investment]) / (cost of investment)
The first figure is the net gain or net profit of your investment. To figure out the net gain, take what you’ll earn from your rental property ("gain on investment") and then subtract it from your expenses ("cost of investment"). Then use that number (your "net gain") to divide it by the total cost of the investment.
Again, the issue with this formula is it doesn’t take into account how you pay for your rental property. Instead, decide how you’ll pay for it then use either one of the two calculations below.
Calculating ROI for cash transactions
The good news is that if you purchase an investment property with cash, calculating its ROI is pretty straightforward.
Before using the above formula, let’s use an example scenario:
- You decide to pay $200,000 in cash for your rental property and the closing costs end up being $2,000.
- You had to put in another $8,000 in rehab costs.
- So you ended up spending a total of $210,000.
- Your rental income each month is $1,200 meaning you earned $14,400 for the past year.
- Ongoing expenses incurred include property taxes and insurance, totaling $2,000 for the year, or $166 per month.
With these numbers, you can how calculate the ROI:
Take your annual return ($14,400 – $2,000 = $12,400) and divide it by the total investment amount ($210,000).
Your ROI would be $12,400 ÷ $210,000 = 0.059 or 5.9%
ROI for financed properties
When it comes to rental properties with mortgages, the calculations can get more complex. For the same $200,000 property, taking out a home loan means you’ll pay less initially — you’re paying for closing costs plus a home down payment — but your costs spread out over time due to the ongoing cost of your monthly mortgage payments.
Here’s an example:
- You make a 20% down payment ($40,000), pay for closing costs ($3,000) and $8,000 in rehab costs. Your total upfront investment is now $51,000.
- Now we’re going to assume you have a 30-year mortgage with a 4% interest rate. This means your monthly payment would be $783.86.
- Add that with your $166 in monthly ongoing costs (property taxes and insurance) and your total ongoing costs are $11,398.32 per year or $949.86 per month.
Assuming you earned $14,400, your annual return is $3,001.68.
Therefore your ROI equals $3,001.68 divided by $51,000 and you get 5.8%.
What about home equity?
Although you can certainly add in your property’s equity into your calculations, keep in mind that you’ll need to sell your property to access the cash.
To figure out your home equity, look at your amortization schedule to see how much of your mortgage payments have gone towards the mortgage principal. Then you can add this to your annual return.
For example, let’s say you’ve paid down a total of $2,817.68 of principal in the last 12 months. Your new annual return is now $5,819.36 ($3,001.68 + $2,817.68), therefore your ROI is 11%.
Does this consider cap rates?
The short answer is yes. In a nutshell, cap rates help you to measure the expected return on your rental property with the need to factor in financing. In other words, it’s the ratio of the rental property’s annual income over the acquisition costs.
At the most basic level, measuring the cap rate helps you compare potential investments since it’s one measure of a property’s returns. So if you’re looking at two identical properties, you can use the cap rate to see which one has a better profitability than the other. That means the higher the cap rate, the more income you receive for less cost.
Ultimately, these types of numbers are there to help you figure out what’s the best way to invest your money.
What is a good ROI for rental properties?
The truth is that there isn’t a clear cut answer for figuring out a good ROI for a rental property. That being said, there are some rules of thumb most real estate investors use since certain ROIs may not be worth it—investing in other vehicles like a retirement account might be the better bet.
In more specific terms, you’ll want to aim for your rental ROI to be 5% or more since this percentage means that you’ll earn a higher rate of return compared to typical retirement accounts.
Getting a 5% to 10% return for rental properties is pretty reasonable. That is, assuming you’ve included some bigger for vacancy rate, repairs and other costs. Of course the higher the percentage, the better—just make sure to be thorough in your calculation.
At the very least, ensure that your cash flow is a minimum of $100 per month (though of course there are exceptions).
Here are a few other rules of thumb to take into consideration:
- 1% rule: This rule means that your gross monthly rent should be at least 1% of your property purchase price. It’s sometimes called the cap rate. Of course, the higher the percentage, the better.
- 50% rule: A property’s overall operative expenses should be around 50% of the income. This does not include mortgage payments. So the other 50% the money you set aside for expenses should cover the monthly mortgage payment. This rule is used to estimate the cash flow and profit of your investment quickly.
As with all numbers, you’ll want to consider other factors like turnover rate. For instance, numbers for lower-end properties tend to look more attractive on paper compared to mid-or higher-end properties. However, you’ll probably experience higher turnovers — that means more expenses such as new carpets, painting, repairing any damage and paying for advertising costs.
What else to consider
Aside from factoring in all expenses that are required when owning a rental property, you’ll want to make sure your numbers are as accurate as possible.
In the above scenarios, it was assumed that your future property would be rented out for 12 months. So you’ll want to take into consideration times during vacancies and factor the lack of income during this time into your calculation.
If you plan on financing your property, the less you make on your down payment, the larger your ROI but your mortgage loan balance will be higher. This means that leveraging financing can boost your ROI for the short term since you’ll have lower initial costs.
Whenever you calculate your ROI across multiple properties, ensure that you use a consistent approach so that you can accurately compare which one is best suited to add to your real estate portfolio.
The bottom line
Calculating a new potential rental investment property takes a lot of factors into consideration. Once you have the initial numbers, dig a bit deeper to see whether the property will be a good addition to your real estate portfolio.
You probably know that real estate investing can be complex, but following the above principals can help make it a good general starting point. For example, if you want an initial higher ROI, financing with a lower down payment can help you start investing in real estate without a ton of upfront capital. This can be especially useful if you find a great deal but won’t be able to get enough capital to downright purchase the property.
Don’t forget that every real estate market is different and that the above guidelines may not be 100% accurate for your situation.