The question, how to calculate the ROI on a property investment, is often on the minds of prospective rental investors.
But to get an answer to this question, you’ll first need to understand the various rental property types and the documentation landlords need to assess each investment effectively.
For starters, rental properties can be grouped into two broad categories. That is, long-term- and short-term rentals. Keep reading to learn more!
Long-Term Rentals
A long-term rental property is a property that a landlord rents out for an extended period of time, usually between 6 and 12 months. Examples of such rentals include apartments, residential homes, and commercial buildings.
The tenant is required to pay rent consistently over the duration of the lease term, making rent collection a key aspect of the arrangement. This type of rental property is suitable for landlords looking for stability in rental income.
So, what rate of return should you expect by investing in a long-term rental? There is no straightforward answer! But generally speaking, you could expect anything between 8- and percent annually with a good investment strategy.
Aside from the potential rental yield, you should also expect capital gains appreciation over time.
Short-Term Rentals
As already mentioned, the other rental investment property types are short-term rentals. And similar to long-term rentals, these can also be residential or commercial spaces rented out for a defined period, usually 30 days or less.
Often, landlords renting out these rental units list them on platforms like Airbnb or VRBO.
If you choose to invest in short-term rentals, you should expect an ROI of about 10 percent. However, unlike the income stability that long-term rentals or month-to-month tenancy provide, the income from short-term rentals usually varies.
It can range between 5% and up to 20% depending on the season. Expect a high ROI during the peak seasons and a dip during off-peak seasons.
Other than change of seasons, the ROI on short-term rentals can also vary depending on the property type, location, and efficiency of management.
How Is the ROI on a Property Investment Calculated?
When it comes to calculating ROI on a property investment, there are three key methods you can use. They are as follows:
Return on Investment (ROI)
This calculation is the simplest of the three. To calculate the ROI of a property investment, you’ll need to subtract the cost of investment from the income and then divide by the cost of the investment.
Suppose, for instance, that you invested $80,000 in your rental property. If the profits you made from the investment totaled to $95,000, then the ROI would be 15.79%. ($95,000-$80,000)/$95,000=15.789%.
While you may be able to get a general idea of the expected ROI on a property investment, this formula is fairly basic. It ignores future property value appreciation and is not adjusted for risk.
With that in mind, for more granular calculations, consider using the cap rate or cash on cash return calculations.
Cap Rate
This is one of the most common formulas that budding investors use before buying an investment property. You can use it to calculate both the expected ROI of a property, as well as compare among different investment opportunities.
Ideally, cap rate works best to calculate ROIs for commercial properties rather than other property investment types. The Cap Rate formula is a ratio between an investment property’s net operating income and its cost of purchase.
Suppose, for example, that you bought your rental investment for $200,000. Also, suppose that the cost of closing on the property and remodeling it were $1,500 and $10,000, respectively.
In this case, your total investment cost would amount to $211,500 ($200,000+$10,000+$1,500).
If your tenants pay you $1,000 in monthly rent, you’d gain $12,000 in a year in rental income. However, renting out a property comes with certain operational expenses. Such as, maintenance, insurance, taxes, and property management. Let’s say that such expenses add up to $2,000.
So, your annual return would be $12,000 (annual rental income) - $2,000 (operational expenses) = $10,000.
Next, divide the amount (annual return) by the total investment on the property. $10,000/$211,500 and then multiply the value by 100%. ($10,000X100)/$211,500=4.73%.
According to the calculation, the cap rate would be 4.73%.
Cash on Cash Return (CoC)
This is relatively more complicated. However, it’s an important calculation for any investor looking to take out a mortgage to cover their rental property purchase.
The Cash on Cash Return is a ratio of a property’s net operating income (NOI) and the total investment cost. To get the ratio, you’ll need to divide the annual cash flow by the total investment cost. You can then multiply the ratio by a hundred to get the percentage CoC return.
Suppose, for example, that you bought a property worth $200,000. You then took out a mortgage, which required a 20% deposit. Your total investment cost would then be mortgage deposit ($40,000) + closing costs ($3,500) + remodeling costs ($10,000).
In total, your total investment cost would amount to $53,500.
Please note, however, that when you finance an investment property, a mortgage will require you to pay a certain amount every month as interest. For example, if that amount is $1,000 and you charge a tenant a monthly rent of $1,500, that would leave you with a cash flow of $500 every month.
In a year, the amount would total to $500X12=$6,000. To calculate the ROI on the property, divide the annual cash flow by the total investment cost and then multiply the ratio by 100%. ($6,000X100)/$53,500 = 11.2%.
With that in mind, what is a good ROI on a rental property investment?
Bottom Line
If you’re a first-time investor, due diligence is key before buying your first investment property. Your goal should be to invest in a property that gives you an optimal ROI.
MTD Property Management can help you in this regard. We have been a premier choice for dependable property management services in Chicago, IL for over 30 years now. Get in touch to learn more!
Blog
