For investors who diversify their investment portfolio with real estate, it's important to measure the return on investment (ROI) to determine a property's profitability.
ROI measures how much money or profit is made on an investment as a percentage of the cost of the investment. It shows how effectively and efficiently investment dollars are being used to generate profits.
Calculating a meaningful ROI for a residential property can be challenging because calculations can be easily manipulated—certain variables can be included or excluded in the calculation. It can become especially difficult when investors have the option of paying cash or taking out a mortgage on the property. Here, we'll review two examples for calculating ROI on a residential rental property.
The Formula for ROI
To calculate the profit or gain on any investment, you would first take the total return on the investment and subtract the original cost of the investment. However, ROI is a profitability ratio, meaning it gives us the profit on an investment represented in percentage terms.
To calculate the percentage return on investment, we take the net profit or net gain on the investment and divide it by the original cost.
For instance, if you buy ABC stock for $1,000 and sell it two years later for $1,600, the net profit would be $600 ($1,600 - $1,000). The ROI on the stock would be 60% [$600 (net profit) ÷ $1,000 (cost) = 0.60].
Calculating the ROI on Rental Properties
The above equation seems easy enough to calculate, but keep in mind that a number of variables come into play with real estate that can affect ROI numbers. Those include repair and maintenance expenses and methods of figuring leverage—the amount of money borrowed (with interest) to make the initial investment.
When purchasing property, the terms of financing can greatly impact the price of the investment; however, using resources like a mortgage calculator can help you save money by helping you find favorable interest rates.
ROI for Cash Transactions
If you buy a property outright with cash, calculating its ROI is fairly straightforward. Here's an example of a rental property purchased with cash:
- You paid a $100,000 in cash for the rental property.
- The closing costs were $1,000, and remodeling costs totaled $9,000, bringing your total investment to $110,000 for the property.
- You collected $1,000 in rent every month.
A year later:
- You earned $12,000 in rental income for that year.
- Expenses, including the water bill, property taxes, and insurance, totaled $2,400 for the year or $200 per month.
- Your annual return was $9,600 ($12,000 - $2,400).
To calculate the property’s ROI:
- Divide the annual return ($9,600) by the amount of the total investment or $110,000.
- ROI = $9,600 ÷ $110,000 = 0.087 or 8.7%.
- Your ROI was 8.7%.
ROI for Financed Transactions
Calculating the ROI on financed transactions is more involved.
For example, you purchased the same $100,000 rental property as above, but instead of paying cash, you took out a mortgage.
- The down payment needed for the mortgage was 20% of the purchase price or $20,000 ($100,000 sales price x 20%).
- Closing costs were higher, which is typical for a mortgage, totaling $2,500 up front.
- You paid $9,000 for remodeling.
- Your total out-of-pocket expenses were $31,500 ($20,000 + $2,500 + $9,000).
There are also ongoing costs with a mortgage:
- Let's assume you took out a 30-year loan with a fixed 4% interest rate. On the borrowed $80,000 ($100,000 sales price minus the $20,000 down payment), the monthly principal and interest payment would be $381.93.
- We’ll add the same $200 a month to cover water, taxes, and insurance, making your total monthly payment $581.93.
- Rental income of $1,000 per month totals $12,000 for the year.
- Your monthly cash flow was of $418.07 monthly ($1,000 rent - $581.93 mortgage payment).
One year later:
- You earned $12,000 in total rental income for the year at $1,000 per month.
- Your annual return was $5,016.84 ($418.07 x 12 months).
To calculate the property's ROI:
- Divide the annual return by your original out-of-pocket expenses (the down payment of $20,000, closing costs of $2,500 and remodeling for $9,000) to determine the ROI.
- ROI: $5,016.84 ÷ $31,500 = 0.159.
- Your ROI is 15.9%.
Some investors add the home's equity into the equation. Equity is the market value of the property minus the total loan amount outstanding. Please keep in mind that home equity is not cash-in-hand. You would have to sell the property to access it.
To calculate the amount of equity in your home, review your mortgage amortization schedule to find out how much of your mortgage payments went toward paying down the principal of the loan (which builds up the equity).
The equity amount can be added to the annual return. In our example, the amortization schedule for the loan showed that a total of $1,408.84 of principal was paid down during the first 12 months.
- The new annual return, including the equity portion, equals $6,425.68 ($5,016.84 annual income + $1,408.84 equity).
- ROI = $6,425.68 ÷ $31,500 = 0.20.
- Your ROI is 20%.
Of course, in our examples above, there could be additional expenses involved in owning a rental property, such as repairs or maintenance costs, which would need to be included in the calculations ultimately affecting the ROI.
Also, we assumed the property was rented out for all 12 months. In many cases, vacancies occur particularly in between tenants and the lack of income for those months must be factored into your calculations.
However, the ROI for a rental property is different depending on whether the property is financed via a mortgage or paid for in cash. As a general rule of thumb, the less cash paid upfront as a down payment on the property, the larger the mortgage loan balance will be, but the greater your ROI. Conversely, the more cash paid upfront and the less you borrow, the lower your ROI, since your initial cost would be higher. In other words, financing allows you to boost your ROI in the short-term since your initial costs are lower.
It’s important to use a consistent approach when measuring the ROI for multiple properties. For example, if you include the home's equity in evaluating one property, you should include the equity of the other properties when calculating the ROI for your real estate portfolio.