ROI on Rental Property
What is ROI in Real Estate?
In real estate, the concept of return on investment measures how profitable a real estate investment has been relative to the cost of the investment. In a simple scenario without a mortgage, we assume that you bought a property for $150,000 and you sold it five years later for $220,000. Your ROI would be:
However, by borrowing money you are able to decrease your initial costs and improve your return on investment. For example, imagine you bought the same $150,000 property with a 20% down payment and 5% closing costs. This means you invested $37,500 and borrowed $112,500. To keep things simple, let's assume that you paid 0% interest on the $112,500 over five years. By receiving a mortgage, your ROI would increase to:
In real life, the calculation isn’t so simple. You must include additional costs associated with the property such as property taxes, mortgage payments, home insurance, and more. Additionally, some people choose to invest in real estate so they can receive rental income every month. These layers must be factored in when we calculate ROI, as we will see in the next section.
How to Calculate ROI on Rental Property
Initially, we calculated ROI as if there were no other cash inflows rather than at the sale of the property. Now we will consider the case, where we rent the property out and collect rental income each month. Things get trickier when we involve various costs related to the purchase, maintenance, and any financial costs such as purchasing a property through a mortgage. All of these will need to be accounted for when we calculate the return on investment in a property.
ROI for rental properties is calculated as follows:
Total Income - To calculate the return on our investment, we will first need to figure out how much income the property will generate. The income usually comes in the form of rent and other income from building amenities.
Operating Expenses - These include the costs associated with the daily operation of the property. Expenses such as property taxes, property insurance, landlord insurance, management fees, maintenance, and minor repairs are included in this category.
Financial Expenses - These include costs associated with purchasing a property by using a mortgage. The interest expense and mortgage payments are to be accounted for in the ROI of real estate.
Imagine that you purchased an investment property for $200,000. To finance the purchase, you took out a 30- year mortgage with a 4.5% interest rate and put a 20% down payment for it. You also paid $3000 in closing costs and $12000 in repairing it.
You decide to rent out the property at a monthly rent of $1500. Maintenance, property taxes, insurance, and utilities will cost you $300/ month.
Using our mortgage payment calculator, you can find out how much your monthly payment will be.
For a 30-Year mortgage at a 4.5% mortgage rate, with a $40,000 down payment, the monthly mortgage payment will be $811 which includes the principal and interest payment.
The cost of investment will equal the down payment you make, closing costs, and any major repairs that qualify as expenditures.
Costs to Include in Rental Property ROI
The most common mistake for real estate investors is underestimating costs or forgetting to budget for specific expenses. When calculating ROI, you should include all the costs associated with owning and operating the rental property. There are three broad categories of rental property costs; financial, operating costs, and capital expenditures.
This category is what most investors think of when budgeting costs. In reality, these are the bare minimum costs. The financial expenses associated with owning a rental property include:
- Mortgage payment
- Property taxes
- Rental insurance
- Closing costs
Operating expenses are the day-to-day costs of running the property. These will vary depending on the type of property and its location. The most common operating expenses include:
- Property management fees
- Accountant fees
- HOA fees
- Repairs and maintenance
- Vacancy allowance
- Snow removal
Capital expenditures are the big-ticket costs associated with improving or upgrading the property. These are typically one-time costs when you buy the property or make significant improvements, such as a new roof or HVAC system. While you don't have to pay these items frequently, setting aside a portion of each rental payment is wise.
Other common capital expenditures include:
- Security deposits
- Pest control
Average ROI in Real Estate
According to the National Council of Real Estate Investment Fiduciaries, for the 10-year ending in the 1st quarter of 2022, the average ROI in real estate has been at 9.6%. We can see this on the graph below by referring to the NPI, which is NCREIF’s index.
There are 4 main categories of real estate to invest in:
- 1. Residential Real Estate - property used for residential purposes
- 2. Commercial Real Estate - properties used for income-generating services
- 3. Industrial Real Estate - properties used for manufacturing, processing, warehousing, or retail purposes
- 4. Land
Each of these classes differs by the return that they offer to an investor. As seen on the graph, industrial properties offer some of the highest returns in real estate and these returns have stayed positive even during the economic crisis caused by COVID-19.
A good ROI in real estate is considered anything above 8%. However, investors should aim for a 10%-12% return.
How to Increase Rental Property ROI
The rental property ROI formula provides clues on increasing your return on investment. There are a few variables you can optimize to receive a better ROI.
Method #1: Increase Total Income
The first method to optimize your ROI is by increasing the property's total income. There are a few ways to do this, but the most common is raising rents. Some landlords will raise rents by renovating a property to attract higher-paying tenants. Another method is to add additional units to the property if zoning laws allow. Increasing the total number of units will generate more rental income without raising rents for existing tenants.
Additionally, landlords can create additional revenue streams by installing washing machines or charging for parking access. Others will introduce late fees for missed rent payments. If you live in an area with a high demand for rental properties, you could also look into Airbnb hosting.
Method #2: Decrease Operating Expenses
The second method of increasing ROI is by decreasing your operating expenses. The most common way to do this is by negotiating better deals with vendors and service providers. You can also consider ways to make your property more energy efficient, lowering utility bills.
Another way to decrease operating expenses is by self-managing your rental property. While this takes up more time, it can save you money in the long run by eliminating the need to pay a professional property manager.
Method #3: Decrease Financial Expenses
The third method of increasing ROI is by decreasing your financial expenses. This can be done by refinancing your mortgage to get a lower interest rate. Lenders generally reward you with a lower interest rate if your credit score increases.
Another financial expense is your rental income taxes. A popular way for landlords to decrease their taxable income is by maximizing yearly depreciation. This can be done by hiring a professional accountant or by taking a DIY approach.
The final financial expense to consider is insurance. Some landlords develop a relationship with an insurance agent and can get a lower rate than what's offered online. You can also increase your deductible to lower your monthly premiums.
Method #4: Minimize Cost of Investment
You can also increase ROI by minimizing the upfront cost of investment. The significant upfront costs are your down payment and closing costs.
If you have home equity in another property, you can use it as a down payment for a rental property. For example, you can borrow from your primary residence using a HELOC.
This will minimize the additional out-of-pocket expenses you pay to purchase the rental property, which optimizes your ROI. However, this is a riskier method due to the high debt you'll be taking on. Additionally, the lender will want to ensure the combined debt payments will not set you over the debt-to-income ratio limit.
You can also try negotiating with the seller to cover some of the closing costs. This will reduce the amount of money you need to bring to the closing table and, as a result, increase your ROI.
Some investors also look into government programs that offer assistance with down payments and closing costs. In the U.S., several down payment assistance programs are available through local and state governments.
Alternative ROI Calculations for Rental Property
While the standard ROI is the most popular method to calculate your rental property return, some alternatives exist. This section will inform you about alternative measures and how to calculate them.
Annualized ROI, otherwise known as the compound annualized growth rate (CAGR) is a method of calculating ROI that shows the yearly return. This calculation is practical when comparing investments with different holding periods.
To annualize your ROI, you begin with adding 1 + your total ROI. For example, if your ROI was 50%, your first step would be 1 + 50%, or 1.50. Afterward, you raise the number to the exponent of one divided by your holding periods. If your investment was five years you would use the power of ⅕. Finally, you subtract by 1 before multiplying by 100. The formula is displayed above.
The cap rate measures how profitable a building is compared to the purchase price. It is a method to quickly compare investments and even value commercial properties. A higher cap rate is more desirable because it shows the building is more profitable. However, sometimes a higher cap rate entails more effort from the landlord, such as Airbnbs.
To calculate the cap rate, you divide the net operating income (NOI) by the property's purchase price. NOI is your rental income profits after operating expenses. You can use an NOI calculator to learn more. For example, you buy a rental property for $100,000. The property generates $10,000 in NOI each year. In this case, the cap rate would be 10 percent.
While one approach to solving cap rate is dividing by the purchase price, another method is using the fair market value of the property.
Internal Rate of Return (IRR)
The internal rate of return (IRR) is a sophisticated ROI calculation that is often used by investment firms. It is based on the idea that $1,000 today is more valuable than $1,000 in five years. This is because you can invest the money today and have more in five years. This concept is known as the time value of money.
To begin calculating IRR, you need to estimate the cash flows associated with the investment over time. A cash flow is the profits you receive from an investment after costs. For example, let's say you invest $100,000 (down payment and closing costs) in a rental property, and it generates the following cash flows over five years. Assume at the end of year five you make $70,000 in profit due to selling the property at a higher price and receiving rental income:
- Year 0: -$100,000
- Year 1: $10,000
- Year 2: $15,000
- Year 3: $20,000
- Year 4: $25,000
- Year 5: $70,000
Your initial cash flow at the beginning (Year 0) is -$100,000 since that's the amount of money you invested. Finally, the best way to calculate IRR is through spreadsheet software such as Microsoft Excel or Google Sheets. After outlying the cash flows, you can simply use the =IRR function to solve. Using spreadsheet software reveals the IRR is 9.13%.