As an investor, you must be able to calculate the ROI on a rental property. The ROI can make or break your opportunity for a successful investment. It’s best to learn the various calculations and apply them before going ahead with any rental property purchase.
The ROI is important because it can give you a clearer idea of the potential returns on a property after all expenses, fees, and taxes. The rental market is always in fluctuation; the ROI calculation gives 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 will I get in return for my investment. ROI is typically given as a percentage over the cost of your investment.
For example, if you pay $200k for rental property and the ROI is 5%, you stand to make $10k in profit.
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 finance, it also changes the ROI calculation. That’s why it’s best to learn all about ROI on rental properties before you go ahead and invest.
How do you calculate the rate of return on a rental property?
There are three key methods for calculating ROI on a rental property.
The Simple Calculation
This is the most basic calculator and looks at the rate of return.
ROI = (Gain from Investment – Cost of Investment)/Cost of Investment
For example, let’s say you invested $100,000 in the rental property, and the total profits made from the investment is $120,000. The rate of return on your investment is:
ROI = ($120,000 – $100,000)/$50,000 = 0.2 = 20%
As you can see, this is a very simple return on rate formula. It uses a lot of general numbers and is not specific enough to give you a clear idea of the profit to be made. The two calculations below are much more detailed and accurate.
Cap Rate Calculation
The cap rate, or capitalization rate, is used by investors who buy their rental property in cash. It can determine the profitability of a rental property, as well as compare multiple property investment opportunities.
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 in cash, $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%. Just under 5% is not a bad return on rental property investment.
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 will change a lot. 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%. You will also meet other property investors who won’t even consider a property unless the calculation predicts at least a 20% return rate. Again, this is down to you as an investor, and what you metric for a good return rate is.
What is the 2% rule?
The “2 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 2% 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 2% 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 2% of the purchase value as your monthly rent.
For example, you buy a rental property for $100,000. Using the 2% rule, you would need to ensure you could charge $2000 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 2% rule isn’t a great rule at all. This is because properties in bad areas will likely meet the 2% rule, and it doesn’t take into account the age or damage of the property.
Therefore, critics say that investors using the 2% rule will end up with properties in poor condition in dodgy parts of towns. The 2% rule also does not consider operating expenses or cash flow.
Therefore, it’s probably only worth using the 2% 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 next one, use the cap rate and cash on cash rate calculations to aid you in making the best investment possible. Feel free to use the 2% rule to quickly screen for a large number of investment opportunities, but don’t use it to make your final decision.
Getting support for a rental property purchase is always a good idea. Here at The Short Term Shop, we can help you with everything, from the investment calculations to the point of sale, to train you to manage your rental property without hiring expensive property managers.
Also, you can use our rental property calculator. This tool allows investors to quickly and effectively evaluate potential short term rental investment property.
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.