In the US real estate market, numerous investors opt to purchase rental property due to its high volatility. When you buy a rental property and its value increases as the years go by, you can charge tenants more. Resultantly, your profit margins are bound to rise!
While this is a noteworthy prospect that might make you tick, you mustn’t get carried away by the purported dividends yet. Although these values are in the mix, you’ll need to understand that ROI calculation plays a significant role in any rental property purchase.
Why? The ROI gives you an accurate hint on what your returns will be like if you decide to go ahead and buy a rental property. Although calculations might seem daunting most times, a foundation on the basics would help you a great deal in attaining that rental property estate you’ve always wanted.
With tourism values fluctuating annually, knowing how to calculate ROI on a rental property is a skill every investor must possess. If you’d like to get an encompassing resource on everything ROI, visit https://theshorttermshop.com/roi-rental-property/.
In this article, we’ll analyze the term ROI, how to calculate it, and the ambits of a good ROI. With the real estate market being a game of numbers, let’s get going!
Also tagged as the return on investment, ROI aims to give investors an idea into the profit or gain margins they’ll be making on a property against the initial investment.
Sounds great, right? Well, it should be. However, people can manipulate the actual return on investment a rental property holds. For more context, the owner of a rental property who wants to make a quick sale can decide to exclude or include some variables for the ROI percentage to look mind-boggling.
So, can you see why knowledge of ROI calculation is a “must-have” for the average investor? If the ROI on investment property isn’t done the right way, you’ll be in for several repercussions in the long run.
Fortunately, we’re here to take you through the process of getting your ROI values correct to the “T.” Without further ado, let’s take a look at how this activity is achieved.
Calculating ROI on a Rental Property: What Goes Into This Process?
On the surface, knowing how to calculate ROI on a rental property might be like a “long shot.” However, if you follow the guiding principles attached, you should get calculations done seamlessly.
Here, we’ll be looking at two effective methods to get this done conveniently and accurately. They include:
The Normal ROI Calculation
Taking things from the most straightforward form has seen us start with the basic calculating system to obtain the “rate of return” of a rental property.
That said, if you’d like to calculate the rate of return on a rental property using this method, apply this formula:
Return on Investment (ROI) = (Income made from investment – actual investment cost)/ actual investment cost
Let’s say you made a rental property investment of $500,000, and the profit margins attached to the property are set at $700,000. Thus, calculate your ROI on that property this way:
Return on Investment = ($700,000 – $500,000)/$500,000 = 0.4
Thus, the total ROI attached to that property is 40 percent.
As you can see, this ROI calculation format comes off as the most understandable. However, it gives you a rough estimate. So, if you’d like something more specific, try the following medium.
Referred to as capitalization rate, the cap rate is typically employed by investors. Besides giving the profit values attached to a specific property, it also compares the actual property’s profits against others on the market.
For investors looking to invest in a rental property short-term, using the cap rate for analysis gives a more specific value as the value of these properties are based on those around and not necessarily their ROI values.
To get an accurate cap rate, you’ll have to get your NOI (Net Operating Income) first. To calculate this, use this formula:
NOI = Rental earnings – operational costs
For example, if the $300,000 rental property you just purchased has a closing cost of $15,000 and a renovation expense of $25,000, your total expenditure comes in at $340,000.
Since it’s a rental property, you decide to start renting units out, and your tenants pay a combined $4,000 monthly.
Thus, you’ll be making $48,000 every year. To get an actual ROI value for the property, you’ll need to remove the expenses attached. Since this is just an analogy, we’ll be placing this number at $8,000.
Now, your returns each year will come in at $40,000.
To get the cap rate of that rental property, use this formula:
Capitalization rate = (NOI ÷ purchase price) × 100%
CR = ($40,000 ÷ $340,000) × 100 = 11.76%
Consequently, the cap rate on your rental property is 11.76 percent.
What Makes a Good ROI?
If you type this query on Google, tons of sites are bound to pop up, all with different values. However, as an investor, there are specific ROI values that you can tag as “useless.” With figures of this nature, you’d be better off investing elsewhere.
However, coming to the prominent bone of contention, a good ROI should be within the ambits of five percent or more. This value is reasonable as most retirement accounts give you less in terms of interest margins.
If you’re able to hit the ten percent ROI mark after removing expenses such as maintenance and renovation costs, you’ve hit the “jackpot” in terms of real estate standards. However, ensure to make calculations monthly so that you can immediately take charge of anything that seems off.
The real estate market is likened to a game of numbers. Therefore, before you make a rental property purchase, it’s essential to understand the calculations involved.
That said, if you know how to calculate the ROI on a rental property, you’re at an advantage. With the two significant mediums we’ve listed above, employing the cap rate format delivers specific ROI values.