Investment rental properties can be an excellent source of passive income. At the same time, before investing, it is important to know how to calculate the ROI of a rental property. ROI, or return on investment, tells you how much money you are likely to make or lose on an investment. The most basic formula for calculating ROI is:
Gain on Investment − Cost of Investment/Cost of Investment
The ROI of a rental property tells you how much income the property is likely to produce compared to the money you are likely to invest to maintain it. The easiest way to calculate ROI on a rental property is to deduct the property’s annual operating costs from your annual rental income and divide that by the total value of your mortgage.
So, what other calculations could also be used to determine ROI on a rental property?
Rental Property ROI Calculator
Here are eight ways for how to calculate ROI on a rental property:
1. Cash Flow ROI
Cash flow ROI is a straightforward calculation that deducts expenses from gross rent to give you your estimated cash flow. This tells you how much money you will have monthly from a rental property based on what comes in versus what goes out.
2. Cash-on-Cash
Cash-on-Cash calculates a rental property’s annual cash flow based on the amount of cash you invested. The formula for cash-on-cash ROI is:
Annual cash flow / Total cash invested x 100
This calculation helps you determine the expected performance of your rental property over a year based on how much you invest in that property.
3. Net Operating Income
Net Operating Income (NOI) calculates the difference between the rental income of a property and your operating expenses and vacancy losses. The formula to calculate NOI is:
4. Rental income – Operating expenses – Vacancy losses
It is important to note that NOI does not consider your mortgage expenses. Therefore, according to industry experts, the calculation method is more suitable for comparing multiple properties.
5. Capitalization Ratebuy
The capitalization rate calculates the estimated return rate by dividing the rental property’s net operating income by the purchase price. The lower the capitalization rate, the lower your risk – and vice versa.
6. Gross Rent Multiplier (GRM)
GRM calculates the ROI by dividing the property’s purchase price by its annual rental income. The lower the GRM, the better your investment. However, it is important to note that the GRM does not consider operating expenses, so it is essential to use other metrics for better analysis.
7. The 2 Percent Rule
The two percent rule is a quick method to calculate ROI.
If the monthly rent you get from your rental property is at least 2% of your purchase price, you will likely generate positive cash flow. Some investors also use the 1% benchmark. While this is a simple calculation, it may not apply to every market. High-demand areas have high property prices, so meeting the 2% threshold may be difficult unless you charge very high rent.
8. Calculating ROI from Property Flips
So, how would you calculate the return on investment on a rental unit that is a property flip? Indeed, some investors want to invest in a fixer-upper. To accurately calculate the ROI for a house flip, you can use this formula:
ROI=(Selling Price−(Purchase Price+Renovation Costs+Holding Costs))/(Purchase Price+Renovation Costs+Holding Costs)
Consider Different Factors
Whatever method you choose, a good ROI on a rental property depends on several factors. These include the property price, the investment amount, the rent, the location, property taxes, property management fees (if any), and mortgage interest. Overall, a good ROI is dependent on your goals and the structure of your rental business. However, for most investors in rental properties, a good ROI to aim for is between eight percent and 12 percent.
In the end, the primary strategy is to use a consistent approach when calculating the ROI for a rental property. Additionally, understanding the importance of ROI is very important as it can help you make the right decision regarding which rental property to consider for investing. A comprehensive ROI analysis will ensure you understand the variables that might be involved, such as the location of the property, the demographic elements, the type of renters in a certain location, amenities that could potentially have an impact on the rent you can charge, the number of vacancies in that particular location and rental listings, and the insurance rates.
Whether you’re buying your first investment property or expanding your portfolio, The Debbie Reed Team is here to help you navigate the Coastal Delaware market and find the right fit for your goals. Let’s chat!
Original post by RE/MAX, LLC