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How to Calculate the Rate of Return on a Rental Property
Posted by: John Crow
Date: February 18, 2021
Investing in real estate can be a great way to make money and accumulate wealth over time. If you end up investing in a rental property, then you’ll be able to earn an income by collecting rent from your tenants. But how do you know whether you’re getting a good rate of return on your rental property?
To determine whether your rental property is a sound investment, you’ll need to calculate the rate of return or return on investment (ROI). Savvy real estate investors look at these metrics to determine the performance of their investments.
Even if you are new to real estate investing, calculating ROI is made simple if you have the right formula. In this guide, we uncover an easy way to calculate the rate of return on a rental property.
Is Your Rental Property a Good Investment?
Owning a rental property can be a smart way to build wealth, especially if you aren’t keen on investing in the stock market. Roughly three-quarters of all single-family rental properties are owned by individual investors.
This makes sense, as with a rental property, your tenants essentially pay your mortgage and you can grow your equity over time. But rental property investments aren’t always a sure thing. That’s why it’s essential that you calculate your rate of return to determine whether your rental property is actually a good investment.
Rate of Return on a Rental Property Calculation:
Every real estate investor should know the essential rate of return formula in order to determine the ROI on their rental property. That rate of return formula is:
ROI = (Net Return On Investment/Cost of Investment) X 100%
Let’s say you invest $40,000 into a rental unit. In the first full year of ownership, The property generates $750 per month in rental income, which totals $9000 for the year. During that same time period repairs, management, and taxes total $3,000. Using the formula above, the rate of return on your investment would be ROI = ( $9000 – $3,000 ) / $40,000 = 0.15 = 15%
This is a very simple rate of return formula and utilizes an estimation of your investment and gains. There are other formulas you can use to determine the performance of your investment, depending on how you paid for your rental property. These include:
Cap Rate
Cap Rate = NOI / Purchase Price × 100%
You use the capitalization rate (or cap rate) when you pay for your rental property in cash. This formula is typically used to compare similar real estate investments.
The cap rate is the ratio between a property’s net operating income (NOI; Rental Income – Operating Expenses) and its purchase price.
Read: Can You Do a 1031 Exchange on an Investment Property?
Cash on Cash Return
Cash on Cash Return = (Annual Cash Flow / Total Cash Invested) × 100%
Real estate investors use the cash-on-cash return formula to calculate the rate of return on an investment property when they utilize a mortgage or loan to pay for the property. The cash on cash return is the ratio of the property’s NOI and the amount of cash invested in the property.
Read: These Cash Flow Fundamentals Delivered Crazy Results!
What is the Average ROI on a Rental Property?
The average rate of return on a rental property is around 10%. Comparatively, the average ROI on commercial real estate is 9.5% and real estate investment trusts (REITs) have an average return of 11.8%.
What is a Good ROI on a Rental Property?
While the definition of a good return on a rental property varies by your risk tolerance, most real estate investors and analysts refer to the average return as a benchmark. Since the average rate of return has been around 10%, anything above that is considered a good ROI.
Using the cap rate formula, you can determine that a good rate of return on your rental property is “good” if it is over 10% or “great” if it is over 12%. However, there are some real estate investors that would say that they won’t invest in a rental property if it doesn’t promise to yield them a 20% return or more.
How to Maximize Your ROI on Your Rental Property
Calculating ROI on your rental property is one thing – actively maximizing your ROI is another. While most landlords can calculate their rate of return, they may struggle to increase their ROI on their rental property.
The best way to maximize your ROI is to work with a property management company that will keep your units occupied and set a competitive rate for your properties. By minimizing vacancies and charging rent that’s on par with the market, your property manager can help you get the absolute best rate of return on your investment.
Read: Home Improvement Tips: What You Should (and Shouldn’t!) Do to Increase Your Home Value
The Bottom Line
As a rental property owner, you should at least be familiar with the rate of return formula and how to calculate ROI on your rental property. This is the surest way to assess whether your rental property is a smart, lucrative investment.
While the simple formula makes it easy to calculate ROI based on your investment and profits, you can use the cap rate and cash-on-cash formulas to calculate ROI depending on whether you paid for your property in cash or with a mortgage/loan.
Still, struggling to calculate ROI on your rental property? We highly recommend working with a property management professional to help you look at your numbers and determine whether your property was a smart investment. It always pays to have an expert on your side!
