Many investors diversify their investment portfolio with real estate. Owning properties can provide investors with steady rental income or capital appreciation when the property is sold for a profit. However, it's important to measure the return on investment properly to determine the level of profitability of the property.

Unfortunately, because ROI calculations can be easily manipulated – and certain variables can be either included or excluded when making the calculation – figuring out a meaningful ROI can be a challenge, especially when investors have the option of paying cash or taking out a mortgage on the property. In this article, we'll review two examples for calculating ROI on a residential rental property.

Return on investment or ROI measures how much money or profit is made on an investment as a percentage of the cost of the investment. ROI shows how effectively and efficiently investment dollars are being used to generate profits. Investors use ROI to determine how well their investment is performing, but also in comparing their ROI with the performance of other investments.

To calculate the profit 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 gain on an investment, we take the net profit or net gain on the investment and divide it by the original cost as shown in the formula below:

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). For more information please read FYI On ROI: A Guide To Calculating Return On Investment.

While the above equation seems easy enough to calculate, with real estate a number of variables, including repair/maintenance expenses, and methods of figuring leverage – the amount of money borrowed (with interest) to make the initial investment – come into play, which can affect ROI numbers.

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.

If you buy a property outright, calculating its ROI is fairly straightforward.

Here is 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 while 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.
- However, there were expenses including the water bill, property taxes, and insurance totaling $2,400 for the year or $200 per month.
- Your annual return was $9,600 for the year ($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%.

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 the same amount of $9,000 for remodeling.
- Your total out-of-pocket expenses wer $31,500 ($20,000 + $2,500 + $9,000).

Plus, there are ongoing costs associated with the 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. (Note: A great tool for calculating the totals cost of a mortgage is a mortgage calculator like the one below.)
- Rental income of $1,000 for a total of $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:

- We 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 towards 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).
- The 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 twelve months. In many cases, vacancies occur particularly in between tenants and the lack of income for those months must be factored into your calculations. (For more, see "How to Value a Real Estate Investment Property.")

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.

Before investing in real estate, be sure to read "The Top 10 Features of a Profitable Rental Property."