One of the main reasons people invest is to increase their wealth. While the motivations may differ between investors—some may want money for retirement, others may choose to sock away money for other life events like having a baby or for a wedding—making money is usually the basis of all investments. And it doesn't matter where you put your money, whether it goes into the stock market, the bond market, or real estate.
Real estate is tangible property that's made up of land, and generally includes any structures or resources found on that land. Investment properties are one example of a real estate investment. These are purchased with the intent to make money through rental income. Some people buy investment properties with the intent to sell them after a short period of time.
Regardless of the intention, for investors who diversify their investment portfolio with real estate, it's important to measure return on investment (ROI) to determine a property's profitability. Here's a quick look at what ROI is, how to calculate it for your rental property, and why it's an important variable you should know before you make a purchase.
- Return on investment measures how much money or profit is made on an investment as a percentage of the cost of that investment.
- To calculate the percentage return on investment for a cash purchase, take the net profit or net gain on the investment and divide it by the original cost.
- If you have a mortgage, you'll have to factor in your down payment and mortgage payment.
- Other variables come into play that can affect your ROI including repair and maintenance costs, as well as your regular expenses.
What Is a Return on Investment (ROI)?
Return on investment measures how much money or profit is made on an investment as a percentage of the cost of that investment. It shows how effectively and efficiently investment dollars are being used to generate profits. Knowing ROI allows investors to assess whether putting money into a particular investment is a wise choice or not.
ROI can be used for any investment—stocks, bonds, a savings account, and a piece of real estate. 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 residential rental property: a cash purchase and one that's financed with a mortgage.
The Formula for ROI
ROI = Cost of InvestmentGain on Investment − Cost of Investment
To calculate the profit or gain on any investment, first take the total return on the investment and subtract the original cost of the investment. Since ROI is a profitability ratio, it gives us the profit on an investment represented in percentage terms.
Because the return on investment is a profitability ratio, the profit is represented in percentage terms.
To calculate the percentage ROI, 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 is $600 ($1,600 – $1,000). ROI on the stock is 60% [$600 (net profit) ÷ $1,000 (cost) = 0.60].
Calculating ROI on Rental Properties
The above equation seems simple enough, but keep in mind that there are a number of variables that come into play with real estate that can affect ROI numbers. These include repair and maintenance expenses, and methods of figuring leverage—the amount of money borrowed with interest to make the initial investment. Of course, financing terms can greatly impact the overall cost of the investment.
ROI for Cash Transactions
Calculating a property's ROI is fairly straightforward if you buy a property with cash. Here's an example of a rental property purchased with cash:
- You paid $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:
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, assume you bought 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 upfront.
- 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, 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.
- Monthly cash flow of $418.07 ($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 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. 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. This builds up the equity in your home.
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%.
Importance of ROI for Real Estate
Knowing ROI for any investment allows investors to be more informed. Before you buy, estimate your costs and expenses, as well as your rental income. This gives you a chance to compare it to other, similar properties. Once you've narrowed it down, you can then determine how much you'll make. If, at any point, you realize your costs and expenses will exceed your ROI, you may have to make a decision about whether you want to ride it out and hope you'll make a profit again—or sell so you don't lose out.
Of course, there may 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.
The ROI for a rental property is different because it depends 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. This can provide the most accurate view of your investment portfolio.