How to Calculate ROI on a Rental Property
Follow this simple guide to learn how to calculate ROI on a rental property.
When you invest in a rental property, you expect to make a profit. But how do you figure out exactly what your return on investment, or ROI, is with a rental property?
Where to start
You can start with the 2% rule to get a handle on whether your rental property is a good investment. This guideline says that if you can rent the property for 2% of the price you pay for it, you’ll make decent cash flow. In many areas, it’s more like 1%. Whichever number you use, it’s a good place to start, but it’s not the whole story.
What are your property investment goals?
Before you jump into the formulas, it’s helpful to reflect on what your ROI goals are. You might plan for your return to come in the form of cash flow. Or, you might be banking on appreciation. If it’s cash flow you want, you’ll likely be investing in a low-cost property and aiming for the rent to exceed your mortgage. If it’s appreciation you’re after, you’re likely in a more expensive real estate market where real estate prices are rising quickly. In that case, rent might just cover your mortgage, but that doesn’t mean you won’t eventually get a good return on your investment.
A few terms to keep in mind
Net operating income. The money a rental property generates after accounting for general expenses. Measured annually.
Cash flow. Net operating income minus mortgage expenses. Measured annually.
ROI with a cash purchase
At its simplest rental ROI is how much money is made on your rental property investment, measured as a percentage of the property’s cost. If you paid cash, here’s the formula: Take the amount of money you’ve made (NOI) and divide it by how much money you paid. So, imagine you paid $250,000 cash for a rental property (including any closing costs or fees) and you made $18,000 on it (factoring in any expenses, see below for a complete breakdown). That’s a return of 7.2%. Of course formulas like this are only as good as the numbers you plug in.
Many people don’t finance their rental properties with 100% cash, which means you’ll need to figure in your mortgage. And every rental property comes with expenses that the owner is responsible for, which you’ll need to include in your calculations.
Monthly operating expenses
It’s helpful to start with finding out how much the rental property costs you on a monthly basis. Here is what’s generally included in the rental operating costs:
- Mortgage (if you have one)
- Property taxes
- Utilities (if landlord pays)
- Remodeling (if applicable)
- Maintenance costs (generally around 1.5% of monthly rental)
- Property Management company fees. Property management companies should be licensed if they are managing a real property on behalf of others for compensation (this is generally about 10% of monthly rent, if using)
- Vacancy costs
- Landscaping maintenance
- Other fees (HOA, etc.)
Take that same $250,000 purchase price, but include financing. Assume you put $50,000 down, paid $2,500 in closing costs and did $5,000 in renovations. You spent $57,500 total out of pocket.
You financed the rest, $200,000, at a 3% interest rate on a 30-year loan. Include property taxes of 1.9% a year and homeowner’s insurance of $1,050 a year. Your monthly combined payment for this is $1,337.
Now, you’ll need to figure in the cost of utilities that you pay as a landlord, any maintenance, management fees, vacancy costs, landscaping, etc. Let’s say the utilities are $100 a month, maintenance is $100 a month, management fees are $100 a month, and the property was vacant for one month ($2,000 a year or $166 a month spread out over the year) This adds up to $466 a month ($5,592 a year) in extra costs.
Add the $1,377 a month in mortgage, taxes, and insurance to the $466 a month in extra expenses and your operating costs are $1,843 a month or $22,116 a year.
Your rental income is $2,000 a month or $24,000 a year in NOI. Take the $24,000 and subtract the $22,116 for your annual return, which is $1,884. Divide your annual return ($1,884) by your total out of pocket costs ($57,500) for your ROI. In this case it’s about 3% of a cash on cash return for the first year. If that all seems complicated, you can use a tool to do the work for you. You can set up ROI tools to look beyond the first year and include appreciation and any other costs you’d like.
What’s the right ROI?
Many investors look to make about 8% on their rental property, while others might want to see 15%. Again, it may depend on your investment strategy. If you can sell the house for double what you paid for it in five years, a low ROI based on rental income might not bother you.