Rental real estate properties are a great way to make money and build wealth. As a landlord, it’s important for you to know how to calculate the rate of return on a rental property to determine its efficacy as an investment.
Every real estate investor knows the importance of the return on investment (ROI) – that popular real estate investment metric used to estimate and evaluate the performance of an investment or to compare the performance of a number of different investments.
However, it can be challenging to figure out the right ROI calculation, as ROI calculations can be easily manipulated. In addition, real estate investors have the option of paying cash or taking out a mortgage on the property; therefore, certain variables can be either included or excluded when making the calculation. Here, we take a look at methods for calculating the rate of return on a rental property.
Rate of Return on a Rental Property Calculation: Simple Formula
By now, real estate investors should know the simple rate of return formula, which is:
ROI = (Gain from Investment – Cost of Investment)/Cost of Investment
So, say you invested $50,000 in the investment property, and the total profits you made from your investment sum up to $70,000. In this example, the rate of return on your investment is:
ROI = ($70,000 – $50,000)/$50,000 = 0.4 = 40%
Keep in mind that this is the simple rate of return on investment formula, and as you can tell, it is very general and includes a lot of estimates and unproven numbers. Other methods used to determine the rate of return on a rental property are mainly the cap rate and the cash on cash return. You determine which one to use depending on how you pay for the rental property.
Rate of Return on a Rental Property Calculation: Cap Rate Calculation
Real estate investors use the capitalization rate (or cap rate, for short) when they pay for the rental property fully in cash. While it’s used to measure the profitability of an investment property, it is more commonly used to compare similar real estate investments.
Cap rate is defined as the ratio between a property’s net operating income (NOI = Rental Income – Operating Expenses) and its purchase price. The formula for calculating the cap rate is:
Cap Rate = NOI/Purchase Price × 100%
The cap rate calculation is a fairly simple one. Assume you bought a rental property and paid $100,000 in cash, $1,000 in closing costs, and $9,000 for remodeling, which makes your total investment in the rental property $110,000. Let’s say your tenants pay $800 for rent every month, which means you’ve gained $9,600 for the year. For a more realistic ROI, we’ll deduct from that cash flow $2,000 per year to cover other expenses that you can’t avoid such as property taxes, property insurance, maintenance, property management, etc. Thus, your annual return would be $7,600.
Now, to calculate the rental property’s ROI, follow the previous cap rate formula and divide the annual return ($7,600) by the total investment you initially made ($110,000).
Cap Rate = ($7,600/$110,000) x 100% = 6.9%.
This means that your rental property’s rate of return is 6.9%.
Rate of Return on a Rental Property Calculation: Cash on Cash Return Calculation
This method of calculating the ROI is a bit more complicated. Real estate investors use this method to calculate the rate of return on a rental property when they take a mortgage or loan to pay for the real estate investment property. The cash on cash return (or CoC, for short) of a rental property is the ratio of the property’s annual NOI and the total amount of cash actually invested in the investment property. So, the formula for calculating the cash on cash return is as follows:
Cash on Cash Return = (Annual Cash Flow/Total Cash Invested) × 100%
Assume you bought the above mentioned $100,000 rental property, but instead of paying in cash, you put a 20% down payment and took a mortgage. Your costs are:
- $20,000 for the down payment ($100,000 purchase price x 20%)
- $2,500 for closing costs (they’re higher because of the mortgage)
- Same $9,000 for remodeling
As a result, your total cash invested is $31,500 ($20,000 + $2,500 + $9,000).
Keep in mind the monthly interest payment associated with the mortgage. Let’s assume for this example it is a total of $500. Assuming your tenant pays $800 every month, you will have a cash flow of $300 per month ($800 rent – $500 mortgage payment). Now, fast forward one year and your net annual income, or return, is $3,600.
Next, use the cash on cash return formula and divide the annual cash flow by the total cash actually invested to determine the rate of return on investment (ROI).
Cash on Cash Return = (3,600/31,500) x 100% = 11.4%.
This is your rental property’s rate of return.
Mashvisor’s Investment Property Calculator
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You can use Mashvisor’s investment property calculator to calculate the previously mentioned real estate metrics – cap rate and CoC return – in addition to the potential rental income and positive/negative cash flow. Furthermore, Mashvisor offers real estate investors detailed neighborhood analysis in the city of their choice, as well as complete property analysis.
Needless to say, this is the best tool for real estate investors for calculating the rate of return on a rental property.
What Is a Good Rate of Return on a Rental Property?
Different experts will give you different answers, and the easiest answer to this question would be “It depends” – on the size of the rental property, the location, the risk associated with the investment, etc. Generally, the average rate of return on investment is anything above 15%.
When calculating the rate of return on a rental property using the cap rate calculation, many real estate experts agree that a good ROI is usually around 10%, and a great one is 12% or more. Conversely, when using the cash on cash return calculation to measure the rate of return on a rental property, real estate experts disagree on what is considered a good ROI. Some say that anything in the range 8-12% is good, while others would not invest in a rental property if it doesn’t promise them 20% return on investment.
The Bottom Line
As a landlord, you should be familiar with how to measure the rate of return on a rental property. Depending on how you buy the rental property – either fully in cash or by putting a down payment and taking a mortgage – you can calculate the rate of return using the cap rate calculation or the cash on cash return calculation. You can use Mashvisor’s investment property calculator to calculate these metrics, in addition to other costs like the potential rental income and positive/negative cash flow.
If you’re looking for a detailed step-by-step type of guide to calculate the rate of return on real estate investment properties, then you’re in luck! Just read this blog.
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