Maintaining a positive real estate portfolio is a lot of work, and it’s impossible without a solid grasp of how your investments are performing. Every investor needs to know how to calculate ROI on a rental property to make informed decisions on whether your next potential buy is a pitfall, or if the benefits of investing outweigh the risk. Aside from helping you with the risk assessment of a new property, ROI calculation can also help identify areas for improvement like increasing your rent, improving your marketing, or reducing your expenses. Read along as we discuss methods that can help rental property investors how to calculate ROI.
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Top 3 Methods to Calculate ROI on a Rental Property
Cash Flow ROI
Keep things basic by comparing how much you invest in your rental to the cash you receive. In other words, you can get an accurate estimate of your annual returns when subtracting your total expenses from your income. This method uses a pretty straightforward formula, i.e:
Cash Flow ROI = (Annual Rental Income – Annual Operating Expense) x 100%
Total Investment
In this scenario, the annual rental income refers to the amount you collect from tenants, while yearly operating expenses include costs like repairs, routine maintenance, and utilities. Operating expenses like hiring a property manager can also impact cash flow. However, some investors confuse their operating expenses with total investment which can skew your results. While the former refers to ongoing fees associated with running a property, the latter includes costs like your down payment, closing fees, and initial renovation.
Capitalization Rate
Calculate your ROI by considering how your property stacks up to similar houses on the market. Capitalization rate is another quick way to determine your ROI by comparing your net income to your property’s current market price, making it easier to evaluate how much value your investment generates relative to its value.
Cap Rate = Net Operating Income (NOI) x 100%
Purchase Price
Despite being unable to account for potential appreciation, a cap rate is still a popular tool for investors looking to compare similar properties and make quick decisions. As long as you get accurate estimates of your Net Operating Income (annual rental income minus annual operating expenses) and Purchase Price (current market value), you should get reliable figures that’ll help you avoid costly mistakes.
Cost Method
Get the long-term picture of your property’s value with the cost method. While cash flow and capitalization rate can tell you a lot about a property’s present worth, if you’re considering long-term investments then you need to use a more holistic approach to calculate ROI. Thus, investors in it for the long haul, often opt for the cost method because of its extended use.
However, it uses a more complicated formula than the previous methods:
ROI = [(Selling Price + Total Rental Income Over Holding Period) – Total Investment] x 100%
Total Investment
While the cost method is a helpful tool for determining the potential long-term profitability of a property, it has its shortcomings. Investors need to make accurate estimations of their future selling price and holding period to get an accurate answer, which can be difficult to estimate in an uncertain market. It would be best to use it more as a guide than an absolute prediction.
Factors that Impact the ROI of a Rental
Stable Cash Flow
Keep the rental’s ROI positive by increasing occupancy rates to ensure you always have a consistent income stream. The return on investment depends heavily on your annual income, irrespective of whatever method you prefer to use. As a result, prolonged vacancies can drastically cause your expected returns to differ from your reality. Hence, it would be best to include marketing strategies that attract new tenants to your operating expenses.
Paying Equity
Making a subsequent down payment on your investment property can affect your returns in the long run. A good ROI on rental properties can heavily depend on the goal of the investor, and if yours is increasing your cash flow, paying equity can put more money in your pocket. The more you pay upfront, the lower your monthly mortgage payments, significantly reducing your operating expenses and potentially giving you lower interest rates.
Property Maintenance
Keep your property in good condition to reduce impromptu repairs and inconveniencing your tenants. One of the best ways to improve your property’s ROI is to conduct preventative maintenance that can quickly spot and correct minor issues in your rental before they become major headaches. As a result, proactive landlords who schedule regular inspections and repairs can preserve their property’s value while justifying rental hikes, and attracting new tenants.
Conclusion
Track the rental property’s value by paying attention to metrics that matter. After all, if you don’t know how a property is performing, how can you tell if it’ll be a good purchase, or whether it’s worth the maintenance cost? Figures like your annual income and total investment, are useful for short-term purposes like cash flow rate, or comparing your rental to similar properties using capitalization rate.
However, if you’re more concerned with the long-term performance of a property, you should use the cost method. During your calculation, remember that external factors can also affect your ROI. In other words, your vacancies, equity, and attitude toward maintenance can also affect your returns.
