As an investor, you’ll need to be able to calculate the ROI on a rental property. The ROI will determine the quality of the opportunity for a successful investment. It’s best to get comfortable with the various calculations and learn to use them before getting started with any rental property purchase.
The ROI of a property is very important because it can give you a clear picture of the potential returns on a property after all expenses, fees, and taxes. The tourism market is always in fluctuation; and the ROI calculation can give you a better picture of your investment.
If you’re looking to purchase a new rental property, here is everything you need to know about calculating the ROI.
What is ROI on a rental property?
ROI is an acronym for Return on Investment. Essentially, it means how much profit you will receive in return for the cash investment made. ROI is typically expressed as a percentage of the cost of your investment.
The purpose of the ROI calculation is to give you a clearer picture of whether your investment will be profitable or not. Unfortunately, there is no defined calculation for ROI, and you may find that people include and exclude certain variables to change the result.
Depending on if you’re paying cash or on financing, the ROI calculation will change. That’s why you’ll need to get very comfortable with the analysis before you start making offers on properties.
How do you calculate the rate of return on a rental property?
There are three key methods for calculating ROI on a rental property.
Simple ROI Calculation
As you can see, this is a very simple ROI formula. It uses fairly general numbers and is not specific enough to give you a clear idea of the profit to be made. The following calculations are a little more granular.
The cap rate, or capitalization rate, is a common calculation used by investors when purchasing rental properties. It can determine the profitability of a rental property, as well as compare multiple property investment opportunities against one another. Cap rate is not the most accurate way to analyze a short term rental investment, as the value of a short term rental is based on closed comparable residential properties in the area, rather than based on the income of the property. Cap rate is a much more useful calculation for commercial properties.
The cap rate is the ratio between a property’s net operating income and its purchase price.
Step 1 - Net Operating Income = Rental Income – Operating Expenses
Step 2 - Cap Rate = Net Operating Income/Purchase Price × 100%
For example, let’s say you bought a rental property for $200,000, $1,500 in closing costs, and $10,000 for remodeling. Your total investment would be $211,500.
Now, your tenants are going to pay you $1000 for rent every month. This means you will gain $12,000 annually. To get a clearer ROI, we can deduct $2000 from that number to cover other expenses (taxes, insurance, maintenance, property management, etc.)
Therefore, your annual return would be $10,000.
To calculate the rental property’s ROI, we need to divide the annual return ($10,000) by the total investment on the property, $211,500.
Cap Rate = ($10,000/$211,500) x 100% = 4.73%.
Your total rate of return on the property is 4.73%.
Cash on Cash Return Calculation
The cash on cash return calculation, or CoC, is slightly more complicated but necessary for any investor using finance (mortgage/loan) to cover the purchase of the rental property.
The CoC is the ratio of the property’s annual NOI and the total amount of cash invested in the rental property. The formula is as follows for CoC:
CoC = (Annual Cash Flow/Total Cash Invested) × 100%
For example, let’s say you bought a $200,000 rental property, and you put a 20% deposit and took a mortgage. Your costs will be $40,000 for the deposit, $3,500 for closing costs, and $10,000 for remodeling/fixing up.
The total cash you invested is $53,500 ($40,000 + $3,500 + $10,000).
But remember, when using a mortgage or a loan, you will have an interest payment each month that must be included in your calculation. For example, let’s say that interest is $1000, and your tenant pays $1500 every month.
That means you will have a cash flow of $500 per month.
After one year, your annual return will be $6,000.
Using the CoC formula, we can divide the annual cash flow by the total cash invested in the rental property to discover the ROI.
Cash on Cash Return = (6,000/53,500) x 100% = 11.2%
This is your annual return rate on your rental property.
What is a good ROI percentage?
Depending on who you ask, and what website you read, the answer to this question can differ significantly. The real answer is “it depends” because a reasonable return rate is subjective to the investor and their circumstances, as well as the property’s circumstances (location, rental prices, risks, etc.)
Typically, a good return on your investment is 15%+.
Using the cap rate calculation, a good return rate is around 10%.
Using the cash on cash rate calculation, a good return rate is 8-12%. Some investors won’t even consider a property unless the calculation predicts at least a 20% return rate. Again, this is up to you as an investor, and what your metric for a good return rate is.
What is the 1% rule?
The “1 percent rule” is a general rule of thumb for those investing in rental properties. It’s used to determine how much you should pay to purchase a rental property.
The 1% rule is useful for any investor that has hundreds of opportunities to go through. Going in-depth on every opportunity would take months to complete. The 1% rule helps to minimize your choice and find the best investment quicker.
The rule is, when looking at rental property investment, ideally, you want to charge 1% of the purchase value as your monthly rent.
For example, you buy a rental property for $100,000. Using the 1% rule, you would need to ensure you could charge $1000 in rent per month.
This rule is not full-proof and is used as a general guide to help investors spot a good return among a huge list of potential investments and eliminate any bad deals.
Some critics will argue that the 1% rule isn’t a great rule at all. This is because properties in bad areas will likely meet the 1% rule, and it doesn’t take into account the age or damage of the property.
Therefore, critics say that investors using the 1% rule will end up with properties in poor condition in dodgy parts of towns. The 1% rule also does not consider operating expenses or cash flow.
Therefore, it’s probably only worth using the 1% rule to quickly screen a vast number of property investment opportunities. It should not be the only calculator you use. Instead, use the much more full-proof calculations, such as the cap rate and cash on cash rate calculations.
If you’re in the market for your first rental property or your tenth, the cash on cash return calculation is arguably the best calculation to aid you in choosing the best investment. The 1% rule can quickly screen a large number of investment opportunities, but don’t use it to make your final decision.
Getting support for a rental property purchase can be difficult. Here at The Short Term Shop, we can help you through the process, from the investment calculations to the point of sale, to training you to manage your rental property without hiring expensive property managers.
Contact us at 800.898.1498 or email us at firstname.lastname@example.org to speak to one of our professional team members. We look forward to assisting you.