Real estate is widely considered the best and more consistent investment around. However, calculating the value of your investment is more challenging than checking your monthly bank statement. Multiple ways to calculate your return on investment (ROI) for a rental property exist. How you choose to do so depends on your situation.
In this article, we’ll discuss the importance of calculating ROI for real estate and then show you how and when to calculate ROI for:
- Cash flow
- Cash-on-cash return
- Capitalization rate (cap rate)
Here’s how to calculate ROI on a rental property:
Why You Should Calculate ROI On A Rental Property
Your ROI measures how efficient your investment is when generating returns. Historically, property values increase faster than inflation. In addition, real estate investors can enjoy monthly cash flow from rental income and multiple tax benefits like depreciation deductions and operating expenses. Other investments don’t have these to offer—at least not simultaneously.
However, if you need to consider the many benefits of real estate, it’s easier to determine your total ROI. You need to accurately measure ROI to know how lucrative or costly your investment is.
That said, calculating ROI isn’t always a simple equation. Different real estate investors are looking for different things. Some investors are looking for their monthly or annual cash flow, others are more interested in the ROI of appreciation, and others need to learn the difference. We’ll cover the basic equations for each of these and much more.
Your cash flow is how much you have left over from your rental property each month after paying your operating expenses and saving money you may need for repairs.
In other words:
Cash flow = total monthly rental income – total expenses
Let’s assume Jackie is trying to calculate her monthly cash flow. Here’s how she’ll do it:
|Monthly rental income||$1,600|
|Monthly mortgage payment||$625|
|Property management fees (10% of rental income)||$160|
|Repair reserves budget(10% of rental income)||$160|
|Vacancy reserves budget(5% of rental income)||$80|
|Net monthly cash flow(or net operating income—NOI for short)||$320|
According to experts, “good” cash flow is $100-$200 per monthly unit, so Jackie is making a good return. However, what one real estate investor considers “good” another investor may find disappointing. If Jackie only earned $320/mo on a $2 million property, that’s not a great deal for her. If the $320/mo is for a $25,000 property, that’s a different story.
While cash flow is one metric to measure ROI, experienced investors will be more interested in the cash-on-cash returns of their rental properties—and you’ll see why.
Your cash-on-cash return is the percentage of your investment in net cash flow in a year. This equation is:
Cash-on-cash return = (Monthly cash flow * 12) / Initial out-of-pocket costs
Let’s reuse the equation to determine Jackie’s net monthly cash flow:
Annual cash flow = $320 * 12
Annual cash flow = $3,840
Now, let’s calculate her total out-of-pocket expenses. The purchase price of Jackie’s rental property was $150,000. She made a 20% down payment, or $30,000. She also paid 2% in closing costs, another $3,000, and fronted an additional $5,000 to cover renovation costs.
In total, her initial pockets costs are: $38,000 (down payment + closing costs + renovations)
Now, we can calculate Jackie’s cash-on-cash return:
Cash-on-cash return = $3,840 / $38,000
Cash-on-Cash return = 0.101 = 10.1%
In the last year, Jackie made 10.1% back on her initial investment.
Some real estate investors are happy with a 10.1% return, while others will suggest Jackie aim for something closer to 12%. Real estate investors want to outpace the stock market, which has averaged 6% and 7% returns for the last several decades. However, the S&P 500’s compound average annual growth rate for the last 30 years (2022 excluded) is 9.89% per year.
If you want to improve your annual cash-on-cash return, here are a few simple things you can do:
Research how much people pay monthly rent for similar properties in your neighborhood. If Angela charges her tenants $1,675 across the street, you probably can, too. Before you do, make sure you give your current tenants plenty of notice. If they decide to vacate the property at the end of their lease, you’ll have more time to find new tenants without digging into your vacancy reserves.
With an extra $75/mo, Jackie’s net monthly cash flow increases to $395. Then, her cash-on-cash return is:
Cash-on-cash return = ($395 * 12) / $38,000
Cash-on-Cash return = 0.1247 = 12.47%
An extra $75/mo adds an additional 2.37% to her cash-on-cash ROI.
If you’re not looking to raise the rent or your tenant still has another nine months on their lease, you could also refinance your loan to lower your mortgage payment. If Jackie can reduce her payment by $75, she will enjoy the same cash-on-cash return as seen in the example above.
Adjust Your Reserves
Jackie puts 5%, or $80, into her vacancy budget each month. However, Jackie’s tenant has lived there for five years, so she has $4,800 saved in her reserves budget. That’s enough to cover three months’ worth of vacancy. Instead of continuing to add to her reserves, she could remove that budget line item and bring her net monthly cash flow to $400. That would get her total cash-on-cash return to 12.63%.
If Jackie’s stashed a pretty penny in her repair reserves budget, she can adjust that instead and realize a higher cash-on-cash return.
The cap rate formula is perfect for deciding what property to buy. Your cap rate is the expected rate of return for your investment based on how much you think you’ll generate in income.
Here’s the cap rate formula:
Cap rate = annual net operating income/purchase price
Remember, your NOI is your income – expenses.
The goal for cap rates is to get the highest percentage possible. The higher the percentage, the faster you’ll achieve ROI.
Calculating a property’s cap rate is important because:
- You can compare investment properties: If you’re torn between two different investment properties, use the cap rate formula to determine which will have a higher ROI. That’s the property you should buy.
- You can determine a property’s profitability: The cap rate compares the income you’re receiving to what you’re paying for the property.
- It helps you estimate your payback period: Your cap rate percentage will indicate how long it will take to pay back your investment. If your cap rate is 10%, it’ll take you ten years. If it’s 5%, it’ll take you 20.
Jackie is torn between two properties:
- Property 1 has a market value of $500,000, an annual income of $75,000, and annual expenses of $40,000.
- Property 2 has a market value of $600,000, a yearly income of $85,000, and annual expenses of $45,000.
Cap rate for Property 1:
Cap rate = ($75,000 – $40,000) / $500,000
Cap rate = 0.07 or 7%
Cap rate for Property 2:
Cap rate = ($85,000 – $45,000) / $600,000
Cap rate = 0.667 or 6.67%
Based on the cap rate formula, Jackie should buy Property 1.
However, before she buys, there’s one more thing to consider: these calculations are based on the current market, rental income, and operating expenses of the property. If Jackie renovates the property and increases its value by $100,000, then charges more in rent, the cap rate equation will change. For that reason, you should also calculate a property’s after-repair value (ARV), the cost of renovations, and what you’ll charge tenants. Then, compare that to the current cap rate calculations.
If you’d like to see the cap rate on steroids, read about calculating the internal rate of return (IRR).
Last but not least is appreciation, which is the increase in your property’s value. Calculate your appreciation if you want to buy and hold your rental property.
Let’s say Jackie bought her rental property for $150,000 in October 2007 and is selling it for $450,000 in October 2022; and wants to know her home value appreciation rate. Here’s how she can find it:
A = P * (1 + R/100) n
- A = Appreciated value
- P = Purchase price
- R = Rate of appreciation
- n = Number of years after the purchase
400,000 = 150,000 * (1 + R/100) 15
Jackie’s home value appreciation rate is 7.60% per year.
Unfortunately, Jackie had yet to learn that, in 2007, her rental property would be worth three times its market value in 2022. In an alternate reality, her property could only be worth $200,000, not $450,000.
For appreciation to work in your favor, live by the classic real estate mantra, “buy low, sell high.”
While we can’t predict the future, up-and-coming cities and neighborhoods with many of the following attributes are more likely to have higher appreciation rates:
- Job growth
- Population growth
- High occupancy rates
- Diverse economy
- High wages
- Excellent lifestyle amenities
- Infrastructure development
Calculating ROI On A Rental Property
What equation you choose to use depends on your circumstances:
- Use the cap rate formula to determine which property you’d like to buy, but remember to include the ARV, rent increases, and renovation costs in your calculations.
- Use the cash-on-cash return formula to determine your annual ROI and compare it to how other investments are doing. Adjust your cash flow spreadsheet to improve your net operating income to enjoy better returns.
- If you’re considering buying and holding long-term, use the appreciation formula to determine how much your rental property is increasing in value each year.
For more information, read about the two biggest mistakes in calculating rental property returns, and dive deeper into cap rates. Also, check out our forums to get answers to any real estate relations questions you may have.
Run Your Numbers Like a Pro!
Deal analysis is one of the first and most critical steps of real estate investing. Maximize your confidence in each deal with this first-ever ultimate guide to deal analysis. Real Estate by the Numbers makes real estate math easy, and makes real estate success inevitable.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.