Rental Property: How to Calculate the Rate of Return?

There are some popular businesses known for money-making, and real estate is one of them. If you want to invest in real estate, it is essential to know the basics. You should know how to calculate the rate of return for the property you are planning to buy. It will help you to understand the efficiency of that particular property.

Return on Investment or ROI is the tool that is used to evaluate the performance of an investment. You can calculate ROI for different properties, and comparison will be easier for you. However, you have to do these calculations very carefully, as it's easier to manipulate ROI. Moreover, other variables can be included and excluded in these calculations. For instance, if you are paying cash, ROI will be different, and its value will be different if you are taking out a mortgage. So, for the precise calculation of the ROI, we are discussing different methods here.

A simple formula to calculate Rate of Return

There is a very simple formula for this calculation, which every real estate investor should know. The formula is as follows.

ROI: (gain from investment – cost of investment) Cost of Investment

For instance, if you have invested $60,000 and the profit you made is $80,000. The rate of return on your investment will be ROI = ($80,000 - $ 60,000)/$60,000= 0.33 = 33%

This is a very general formula, which is based on estimation only. There are other methods too. For example, you can use these methods according to the mode of payment, which you use to buy that property.Cap Rate calculation for ROI

This is also called capitalization rate; this formula is used to pay total cash to buy that rental property. This formula is used to calculate the profitability of a property. But investors also use it to compare the efficiency of different real estate investments. Cap rate is a ratio between NOI and its purchase price. The NOI stands for net operating income, which we calculate as the difference between rental income and operating expenses. If we state it in the form of a formula, it will be

Cap Rate: NOI /Purchase Price x 100%

This formula is also simple to calculate. Suppose you brought a property, and you paid $ 100,000 cash amount for that. $1000 was the closing cost of this property, and you paid $9,000 for remodeling. The total cost of the rental property is $110,000 now. Now we come to the income, and your tenant pays you $ 800 per month. The yearly income is $ 9,600. We have to deduct some expenses from this money, like property tax, insurance, maintenance charges, etc.; suppose these charges are $2,000 per year. So, your annual income is $ 7,600.

Now, you can use the cap rate formula and divide the annual return, which is $7600, by $110,00, our total investment. Now the calculation will be

Cap Rate: ($7600/$ 110,000) x 100% = 6.9 %

The Rate of return for your rental property is 6.9%

Cash on Cash return calculations for ROI

This method is slightly complex as compared to previous methods. This method calculates the rate of return on investment when investors take a loan or mortgage. The cash on cash or CoC ratio is the annual NOI of that property and the amount of cash you have invested. So, the formula for calculations will be

Cash on cash return = (Annual cash flow /Total Cash invested) x 100%

Suppose you have not paid the cash to buy the property. Instead, you have only paid 20% of the down payment, and the rest is the loan. The costs involved here will be $20,000, which you have paid as a down payment. In addition, $2,500, which is the closing cost of the property, and $900 is the remodeling cost. This total cost is $ 31,500. Now you have mortgaged the property, so the monthly interest will also be part of your calculation. Assume that you have to pay $500 interest. If your renters pay $800 per month, your share will be $300 only as $500 will be taken by the loan provider. After one year, your net annual income will be $3600. Now we can use the same old formula to calculate ROI.

Cash on cash return = (3,600/31,500) x 100 % = 11.4%

This is the rate of return on your property.

Investment property calculators can help.

If you are afraid of these complex calculations, you can get property calculators online. There are various platforms, which offer accurate property calculators. They have inbuilt formulas according to different situations. These calculators are considered the best tools to calculate return on investment. Free options are also available, but they are not reliable.

Is there any ideal rate of return for a rental property?

This is a common question which every investor asks. But various factors determine the rate of return. These factors can be the size of the property, its location, risks involved with the purchase, etc. however, if the rate of return of your rental property is above 15%, we will consider it reasonable. If you use cap rate calculations, the ROI of more than 10% is considered as good. Similarly, experts will call it a good investment on the cash-on-cash return calculator if your answer is 8 to 12 %.

The verdict

As a property investor and landowner, you must know these calculations about return on investment. You can buy a property by paying the total cash or can mortgage it too. Use the appropriate calculator to know ROI. You can also use online sources for easier and quicker calculations. However, make sure you include all the variables in your calculations. If these statistics are correct, you can choose a suitable investment at the right place. If the ROI is less than 8%, try not to invest in this property. Most people go for 20%, but anything above 12% is worth investing.

If you’d like to talk more about property management, or you need help with Everest Property Management, please contact us at Everest Realty.

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