Real estate is widely considered to be the best and most consistent investment out there. 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. The way you choose to do it 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 back against cash
- 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 in generating returns. Historically, property values rise faster than inflation. Additionally, real estate investors can enjoy monthly cash flow from rental income and multiple tax benefits such as deductions for depreciation and operating expenses. Other investments don’t have this 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 expensive your investment is.
That being said, calculating ROI is not always a simple equation. Different real estate investors look for different things. Some investors are looking for their monthly or yearly cash flow, others are more interested in the ROI of appreciation, and still 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 of your rental property you have left each month after you pay your operating expenses and save any money you may need for repairs.
In other words:
Cash flow = total monthly rental income – total expenses
Suppose Jackie is trying to calculate her monthly cash flow. This is how she will 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 experts, the “good” cash flow is $100 to $200 per unit per month, so Jackie is earning good returns. However, what one real estate investor considers “good,” another investor may find disappointing. If Jackie only made $320/month on a $2 million property, that’s not much for her. If the $320/mo is for a $25,000 property, that’s a different story.
cash back against cash
While cash flow is a metric for measuring ROI, seasoned investors will be more interested in the cash-on-cash returns of their rental properties, and you’ll see why.
Your cash-on-cash yield is the percentage of your investment in net cash flow in one year. This equation is:
Cash Back on Cash = (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 your total out-of-pocket costs. The purchase price of Jackie’s rental property was $150,000. He made a 20% down payment, or $30,000. He also paid 2% of the closing costs, another $3,000, and advanced an additional $5,000 to cover renovation costs.
In total, your initial out-of-pocket costs are: $38,000 (down payment + closing costs + renewals)
Now, we can calculate Jackie’s cash-on-cash yield:
Cash vs. Cash Return = $3,840 / $38,000
Cash on Cash Yield = 0.101 = 10.1%
In the past year, Jackie has recovered 10.1% of her initial investment.
Some real estate investors are happy with a 10.1% yield, while others will suggest that Jackie aim for something closer to 12%. Real estate investors want to outperform the stock market, which has averaged 6-7% returns for the past several decades. However, the average compound annual growth rate of the S&P 500 over the past 30 years (excluding 2022) is 9.89% per year.
If you want to improve your annual cash-on-cash yield, here are some simple things you can do:
increase the rent
Find out 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 doing so, be sure to give the current tenants plenty of notice of it. If they decide to vacate the property at the end of your lease, you’ll have more time to find new tenants without digging through your vacancy pools.
With an additional $75/month, Jackie’s net monthly cash flow increases to $395. So your cash-on-cash yield is:
Cash back in cash = ($395 * 12) / $38,000
Cash on Cash Yield = 0.1247 = 12.47%
An extra $75/mo adds an additional 2.37% to your cash-on-cash ROI.
If you’re not looking to raise your rent, or if 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 back as in the example above.
Adjust your reservations
Jackie puts 5%, or $80, into her vacancy budget each month. However, Jackie’s tenant has lived there for five years, so he has $4,800 saved in his reservation budget. That is enough to cover three months of vacancy. Instead of continuing to add to his reserves, he could eliminate that line item and bring his net monthly cash flow to $400. That would bring your total cash-on-cash return to 12.63%.
If Jackie has saved a penny in her repair reserve budget, she can adjust it and get a higher cash-for-cash return.
The cap rate formula is perfect for deciding which property to buy. Your cap rate is the expected rate of return on your investment based on how much you think it will generate in income.
Here is the formula for the capitalization rate:
Capitalization rate = annual net operating income / purchase price
Remember, your NOI is your income – expenses.
The goal of capitalization rates is to get the highest percentage possible. The higher the percentage, the faster you will achieve ROI.
Calculating the capitalization rate of a property is important because:
- You can compare investment properties: If you are split between two different investment properties, use the cap rate formula to determine which will have a higher ROI. That is the property you should buy.
- You can determine the profitability of a property: The capitalization rate compares the income you receive with what you pay for the property.
- Helps you estimate your recovery period: Your cap rate percentage will indicate how long it will take to recover your investment. If your capitalization rate is 10%, it will take ten years. If it’s 5%, it will 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, an annual income of $85,000, and annual expenses of $45,000.
Capitalization rate for property 1:
Capitalization rate = ($75,000 – $40,000) / $500,000
Cap rate = 0.07 or 7%
Capitalization rate for Property 2:
Capitalization rate = ($85,000 – $45,000) / $600,000
Cap rate = 0.667 or 6.67%
Based on the cap rate formula, Jackie should purchase Property 1.
Before you buy, though, 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, he must also calculate the after-repair value (ARV) of a property, the cost of renovations, and what he will charge tenants. Then compare that to current cap rate calculations.
If you want to see the cap rate for steroids, read about how to calculate the internal rate of return (IRR).
Last but not least is appreciation, which is the increase in value of your property. Calculate your appreciation if you want to buy and keep your rental property.
Let’s say Jackie bought your rental property for $150,000 in October 2007 and sells it for $450,000 in October 2022; and she wants to know the appreciation rate of her house. This is how she can find it:
A = P * (1 + R/100) N
- A = appreciated value
- P = purchase price
- R = Appreciation rate
- n = Number of years after purchase
400,000 = 150,000 * (1 + R/100) 15
Jackie’s home value appreciation rate is 7.60% per year.
Unfortunately, Jackie hadn’t yet learned that, in 2007, her rental property would be worth three times its market value in 2022. In an alternate reality, her property might only be worth $200,000, not $450,000.
To make appreciation work in your favor, follow 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
- Great lifestyle amenities
- infrastructure development
ROI calculation on a rental property
The equation you choose to use depends on your circumstances:
- Use the cap rate formula to determine which property you’d like to purchase, but remember to include 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 the return on other investments. Adjust your cash flow spreadsheet to improve your net operating income and enjoy better returns.
- If you are considering long-term buy-and-hold, use the appreciation formula to determine how much your rental property increases in value each year.
For more information, read about the two biggest mistakes in calculating rental property yields, and delve into capitalization rates. Also, check out our forums for get answers to any questions about real estate relationships that you may have.
Run your numbers like a pro!
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BiggerPockets Note: These are opinions written by the author and do not necessarily represent the views of BiggerPockets.
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