ROI for Rental Properties and Why It Matters
August 23, 2023
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Calculate ROI For Your Properties
There’s a lot to keep in mind when purchasing your first investment property.
To be successful, you need to be constantly aware of the various factors affecting your revenue, expenses, and overall profitability. One critical metric to know is return on investment, or ROI.
In this article, we’ll discuss ROI for rental properties, how to calculate it, and why it matters for new landlords to be aware of the potential return of their investments.
What is ROI?
In real estate, return on investment, or ROI, is a measure of your property’s profitability that compares your initial investment with the potential returns. It measures how efficiently the original funds you used to purchase or finance a property are being put to work to generate revenue and create a profit.
Although it’s impossible to know exactly how much money you’ll spend and take in for a given property before you buy it, calculating an estimate can give you an idea of whether it’s a good idea to purchase that property. If the costs exceed the expected income, it may not be wise to invest in that property.
How to Calculate Rental ROI
The next thing you probably want to know is how to calculate ROI on rental property.
The formula you need to calculate ROI on rental property is straightforward: ROI is your property’s annual return divided by the initial investment or purchase price.
ROI = Annual return / Initial investment
It’s a simple formula, but finding the values to plug in for both pieces can be a bit tricky. Your annual return is your yearly income minus yearly expenses, so you need to know the rent amount you’ll charge, monthly expenses like repairs and insurance, and other fees like property taxes. Likewise, your initial investment may be difficult to determine if you finance the property with an adjustable-rate mortgage or have to pay additional costs like personal mortgage insurance.
Here’s an example to show how this calculation works in practice. Let’s say you purchased a duplex with cash for $250,000. Because you paid in cash, you can consider this your initial investment.
Now let’s calculate your annual return. Let’s say you plan to rent out each unit at $1,400. This multiplies to $2,800 each month or $33,600 per year, which is your annual income. You’ll also need to know your annual expenses. You likely can’t predict everything you’ll need to spend money on for your property, but some of your expenses could include:
- Property taxes
- Repairs and renovations
- Tenant turnover and vacancies
- Tenant screening
- Eviction costs
- Township/city inspections, licenses, zoning costs, etc.
- HOA fees
For the sake of our example, let’s say your annual expenses for this property are around $6,100. Here’s where we stand with our formula:
ROI = Annual return / Initial investment
ROI = Annual income – annual expenses / initial investment
ROI = $33,600 – $6,100/ $250,000
ROI = $27,500 / $250,000
ROI = 0.11
For this deal, your ROI would be 11%.
Calculating ROI for a Financed Property
In our example above, you paid in cash for your property. But it’s much more likely that you’d finance your property. Instead of a single initial investment, you’ll have a one-time down payment and a series of monthly payments toward the loan.
Using the same numbers from our example above, let’s say you put down a 20% down payment ($50,000) on the original $250,000 duplex. $50,000 is your new initial investment. But now you have monthly mortgage payments to add to your expenses. According to Bankrate’s mortgage calculator tool, if you have a 30-year fixed rate mortgage at 7.6% per annum, you’d pay around $1,600-$1,700 each month (or around $19,800 per year) towards your mortgage. Here’s how that changes our equation:
ROI = $33,600 – ($6,100 + $19,800) / $50,000
ROI = $33,600 – $25,900 / $50,000
ROI = 7,700 / $50,000
ROI = 0.154
Your ROI is around 15% for this deal.
How to Use ROI to Make Informed Rental Decisions
The higher your ROI, the more profitable your investment is. In general, an ROI of around 10% is considered a strong investment. If your expected ROI is lower than 5%, it’s likely that you’ll end up losing way more money than you make on the property.
If you’re in this boat, you have a few options. You can a) manipulate the factors in the equation to see if you get an ROI around 10%, or b) decide not to purchase the property. If your percentage is above 5%, it’s often worth it to play around with the numbers and consider different possibilities before you throw in the towel and give up on a promising option.
For instance, what happens when you increase the rent by a few hundred dollars? What if you add another kitchenette and bathroom to add another dwelling unit to the property? What if you self-manage your rental using property management software instead of hiring an expensive property manager? Plugging in different values into an ROI calculator can help you form an idea of what would need to happen for a property to be profitable.
It’s also important to note that ROI is not a perfect calculation, nor does it include every factor that affects what you perceive as “success” in real estate. For instance, ROI does not consider how long you hold the investment. It also assumes that you’ll have no vacancies in the 12-month period. In reality, all kinds of unexpected things can happen during a year of renting out your property. It’s best to factor in some room for error—aim for 10% ROI or above so that you know you’ll have room to work with should something go wrong.
Skills like knowing how to calculate ROI on rental property can help you make realistic and educated decisions about your rental business. Like any investment, you can’t be certain of its success. But doing your research and considering ROI can mitigate a lot of the risk you’ll be undertaking, no matter if it’s your very first deal or your fifty-first.