Deciding to purchase a rental property is a big step and likely something you’re doing to increase wealth or diversify your portfolio. Either way, you want to be sure this step is going to reap the benefits you’re anticipating: give you a good return on your investment, or ROI. What is ROI? How do you calculate it based on the property you’re interested in? Will it all be worth the investment in the long run?
Understanding How to Calculate the ROI on a Rental Property
To calculate the ROI, you first need to understand what return on investment, or ROI is. This is a term used to describe the value of something you’re investing in. What is the profit going to be? And by the traditional definition of profit, what will you make off of this after you’ve accounted for what you’ve spent? Ultimately, ROI helps you determine if the purchase, in this case on a rental property, is going to be worth the investment.
The ROI Formula and How to Use it
Determining the ROI on something isn’t just in the real estate world. Pretty much every investment you make you’re anticipating some sort of return on that investment. From not only just real estate but to your day to day purchases, the stock market, and the marketing industry in general. The precise formula to calculate the ROI depends on what you’re investing in but in this instance, the ROI formula for real estate is simple.
First, you’ll determine the net gain by subtracting investment cost from the investment gain. Then, you’ll take that number and divide it by investment cost. This will give you the percentage ROI on a rental property, or anything you’re looking to determine the ROI on. There are a few differences when it comes to all-cash purchases or financed transactions, but ultimately, it is the net profit divided by the original cost to determine the ROI on your rental property.
ROI for Cash Purchases
Determining the ROI on a rental property when you’ve paid cash is a little easier to figure out. Let’s say you pay all cash for a rental property totaling $100,000. You made a few updates for $15,000 and ended up paying $2,000 for closing costs. The total investment is $117,000. You’ve decided you’re going to charge $1500 per month for rent. Over the course of the year, you’ve collected rent but you’ve also had to cover various expenses and a few updates to the property. Let’s say you spent around $400 a month for these different expenses totaling $4,800.
You’re going to take your annual return ($4,800 in various expenses subtracted from $18,000 from monthly rent payments) and divide that by your total investment ($117,000).
($18,000-$4,8000) ÷ $117,000 = .112 or 11.2%. Your ROI on this property would be 11.2%.
ROI with a Financed Transaction
Let’s say you’re going to finance this transaction. Determining your ROI is going to be a little different. Let’s use the same example from above where you’ve purchased a property for $100,000. You did not pay cash, instead, you took out a mortgage and paid 20% as your down payment. You still had to cover closing costs at $2,000 and the same amount of updates for $15,000. Your total investment is $37,000. You also have to account for the costs associated with taking out a mortgage. Let’s say your mortgage payment, including interest, is around $500 a month. You’re still spending $400 a month on expenses making your monthly cost $900. You’re getting $1500 a month in rent so when you subtract the $900 of your costs from $1500, your monthly return is $600.
To determine your ROI with a financed transaction, we’ll use the same formula with some varied numbers. Your annual return is the amount you made over the course of the year in rent with the total cost of expenses subtracted from it. We’ve determined your monthly return is $600 ($1500 rent – $900 of your own expenses = $600.) Your annual return is $600 multiplied by 12 totalling $7,200.
Next you’ll take that annual return and divide it by your out of pocket expenses. In this instance, your out of pocket expenses totaled $37,000 ($20,00 down payment + $15,000 for updates + $2,00 for closing).
$7,200 ÷ $37,000 = .194 or 19.4% Your ROI on this same property but with a financed transaction would be 19.4%.
How to Calculate and Maximize ROI on a Rental Property
There are always going to be varying numbers and parts of the equation that could alter that final ROI percentage. Essentially, the equation will always be the cost of the investment subtracted from the gain. The gain is likely what you’d make in a set timeframe off of the property. Then, you simply divide that number by your total investment and that is the ROI percentage. Sometimes, determining this and ensuring your numbers are correct can be tricky. You’ll want to find an experienced real estate expert who can walk you through this process with multiple properties ensuring you find the best for you.
Quartermaster Properties has plenty of experienced real estate professionals with the expertise to help you figure out the best rental property based on ROI and walk you through the steps of determining that final number. Contact our office to schedule a time to chat with one of our professionals to get started.
