ROI on Rental Property

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What is ROI in Real Estate?

In real estate, the concept of ROI is the same. That is, it measures how profitable a real estate investment has been relative to the cost of the investment. In a simple scenario, we assume that you bought a property for $150,000 and you sold it 5 years later for $220,000. Your ROI would be:

And the annualized ROI would be:

However, some people that choose to invest in real estate, do so that they can rent the properties out and benefit from collecting rent every month. This needs to be factored in when we calculate ROI, as we will see in the section ROI on Rental Property.

Average ROI in Real Estate

According to the National Council of Real Estate Investment Fiduciaries, for the 10-year ending in the 3rd quarter of 2020, the average ROI in real estate has been at 9.4%. We can see this on the graph below by referring to the NPI, which is NCREIF’s index.

Annualized Returns by Property Type for the 3rd Quarter 2020
Source: NCREIF Property Index. As of September 30, 2020

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.

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.

Example: ROI in 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.

Step 1: Calculate the total annual income
$1,500/month * 12= $18,000/ year
Step 2: Calculate the annual operating expenses
( Property taxes + Property insurance + Maintenance + Utilities ) * 12= $300/month * 12= $3,600
Step 3: Calculate the financing costs

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.

Annual Financing costs= $811/month * 12 = $9,732
Step 4: Find the cost of investment

The cost of investment will equal the down payment you make, closing costs, and any major repairs that qualify as expenditures.

Cost of Investment= 20% * $200,000 + $12,000 + $3000= $55,000
Step 5: Find ROI
ROI = [ ($18,000 - $3,600 - $9,732)/ $55,000)] * 100= 8.49%

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