When buying real estate properties, investors always look for a good return on investment. One of the driving forces behind making smart real estate investment decisions is estimating expected returns before buying. By doing so, you can determine how profitable an investment property is compared to the associated risks and whether or not it’s worth your time and money.
If you’re just getting into real estate investing and don’t know what a good return on investment is and how to calculate it, you’ve come to the right place. Keep reading as we cover the basics, such as the ROI meaning, and a few other things that every investor should know about using the metric in real estate.
What Is Return on Investment?
Return on investment, or ROI, refers to the ratio between the profits and costs from investing in a financial instrument (stocks or bonds) or real estate. ROI measures how much an individual or an entity makes on an investment as a percentage of the initial cost of the investment. The ROI metric allows investors to assess the profitability of a particular investment or compare the profitability of several investments.
Return on Investment Definition in Real Estate
So what is ROI in real estate? In simple words, it is a standard metric that real estate investors use to analyze investment properties. It estimates the percentage of gain or loss in relation to the amount of capital invested in the rental property. Based on its definition, we can tell how important is it to use an ROI calculator to evaluate an investment. The return on investment basically represents the potential of income-producing properties.
Advantages of the ROI Metric
Investors can use the ROI metric to determine whether or not it is feasible to invest in a rental property. It will help them determine if a particular investment is worth their time and money. They will surely be looking for a favorable ROI for all their efforts.
The ROI figure can also be helpful to an investor who is planning to buy their first rental property. Using an investment return calculator allows them to compare several properties in a particular location or neighborhood.
For seasoned real estate investors, by using the ROI metric, they can determine the average return on investment of their portfolio, as well as compare the ROIs of their individual holdings.
Disadvantages of the Return on Investment Measure
It should be noted that several variables come into play when investing in real estate that can affect the return on investment measure. The variables include repair costs, utility rates, maintenance fees, and property taxes, which may go up with time and, thus, lower the rental property’s ROI.
Also, the financing terms (total loan amount and interest rate) and the investment property financing method (conventional mortgage loan, fix-and-flip loan, etc.) affect the cost of investment. It, in turn, changes the calculation of the expected ROI. Logically, If the investment costs are higher, the ROI is lower.
Lastly, the return on investment calculation assumes that the owner or landlord is renting out the property for the entire 12 months of the year. However, in a few cases, the property sees vacancies between tenants, and the ROI calculation must still factor in the absence of income for the vacant period(s).
To address the limitations mentioned above, do not use the ROI measure on its own to calculate potential income from your rental properties. We recommend using other methods, such as the cap rate method and the cash on cash return method, which will be discussed in detail below.
How to Calculate Return on Investment for Real Estate
As mentioned above, calculating the return on investment for real estate involves estimating the percentage of gain or loss in relation to the capital invested in the property. When we talk about gains, we refer to the profit generated by the rental property over a specific period of time. The gain or profit is computed by adding up the rental income and other capital gains from the investment property.
ROI Formula
Calculating the ROI is pretty straightforward. Below is the return on investment formula:
The above formula gives real estate investors a quick way to understand the financial rewards they’ll get from investing in a rental property. You can also compare the ROI of a property to that of others (of the same type and in the same location) to see how well it’s performing in the overall real estate market.
Example of ROI Calculation
To better understand the ROI formula, let us look at an actual example.
Consider Joe, who is a novice real estate investor. He recently bought an income property for $200,000 and paid another $10,000 in closing fees and other related expenses. For the monthly rent, Joe charges his tenants $2,500.
Using the return on investment formula given above, let’s calculate the ROI that Joe can expect from his property:
ROI = [($2,500 x 12) / ($200,000 + $10,000)] x 100
ROI = ($30,000 / $210,0000 x 100 = 14.28%
We can see that from Joe’s total initial investment of $210,000, he can expect an ROI of 14.28%. For perspective, we can compare the figure to that of the other properties in his neighborhood to see if his ROI is a good one.
Alternative Ways to Calculate the Rate of Return in Real Estate
The above ROI formula is very general and includes broad or annualized numbers. So, it may not give an accurate measure of an investment property’s profitability. It is why real estate investors turn to two more specific metrics for analyzing investment properties. These are the cap rate and cash on cash return – you determine which one to use based on how you pay for the rental property.
Cap Rate Formula
Real estate investors use the cap rate (short for capitalization rate) when they buy properties fully in cash. Basically, this metric tells you what the expected returns from a rental property are if you were to pay for it in cash (rather than financing it with a mortgage). Wondering how to calculate the return on investment using the cap rate metric? Simply divide the property’s net operating income (annual rental income – annual operating expenses) by its current market value.
For example, say you’re planning on buying an investment property with a purchase price of $200,000. Let’s also assume that after buying the property, you rent it out for $1,800 a month, which means you’ll gain an annual rental income of $21,600. After estimating your operating expenses (excluding mortgage payments and interest rate), they add up to $3,000. Thus, your NOI would be $18,600. In this example, you’ll get a 9.3% cap rate. Is this a good return on investment ratio?
As we said, there’s no right or wrong answer seeing that this is a subjective question. Yet, when it comes to what’s a good cap rate, experts in the real estate business recommend anything from 4% to 10%. Keep in mind, however, that cap rates of properties vary by city: rental properties in New York have different cap rates from properties in Nashville, for example. Typically, if the average cap rate for a rental property in a city is high, the location is considered profitable for real estate investing.
Related: What Does 7.5% Cap Rate Mean in Real Estate?
Cash on Cash Return Formula
The cash on cash return metric is more frequently used for calculating the return on an investment property. Investors use it to estimate the expected rate of return on a property that they plan to finance with a mortgage loan. So, to calculate the cash on cash return, you divide the NOI by the total amount of cash you actually invested (not the entire purchase price).
For example, say you want to buy the above investment rental property with a purchase price of $200,000. But, instead of paying the full price, you take a mortgage loan and put 20% of its price as a down payment ($40,000). Say that you’ve paid $2,000 for closing costs and invested another $10,000 for remodeling the property. In this case, your total cash invested is $52,000.
Don’t forget that you need to include the monthly payment associated with the mortgage (let’s assume the monthly mortgage payment amount is $500) in the calculation. If you rent out the investment property for the same $1,800 a month, you’ll have a monthly rental income of $1,300 ($1,800 – $500). Your annual rental income equals $15,600. Let’s take out the original $3,000 for rental expenses and your NOI equals $12,600. Finally, the cash on cash return for this investment property will be 24.2%.
As you can see, how you pay for an investment rental property changes what you consider to be a good rate of return. When it comes to good cash on cash return, experts believe anything from 8% to 12% is a good return on investment ratio.
What Is a Good Return on Investment in Real Estate?
The short answer to what is a good return on investment is it depends. The truth is, there isn’t a specific percentage that property investors consider to be a good ROI in real estate on which they base their decisions. After all, the word “good” is subjective.
You might think 10% is a good rate of return, while another investor would consider it a bad one and would only buy rental properties that generate a 20% return on investment. A good ROI figure also depends on several factors, such as the investment property’s location, type, size, age, taxes, expenses, and more. The ROI number to aim for in a certain rental property varies from one investor to another.
Return on Investment Calculator
As a real estate investor, knowing how to calculate the ROI using different metrics is essential for success. But are you worried you’ll get inaccurate percentages and make the wrong investment decision? Thanks to advanced technology, we created an investment tool so you wouldn’t worry about finding the right one for your needs! The tool is Mashvisor’s Investment Property Calculator.
Using our Investment Property Calculator, a real estate investor would simply enter necessary numbers like financing details, start-up costs, and operating expenses. Then, the tool will automatically calculate the numbers and give you an accurate expected rate of return in terms of cap rate and cash on cash return. Not only that, but Mashvisor’s tool also provides readily calculated data for investment properties in the US housing market. In such a way, you’ll be able to find the best properties for sale with high expected returns in a matter of minutes without having to do any calculations on your own!
Related: Mashvisor: The #1 Investment Property Calculator
The Bottom Line
For real estate investors, knowing what a good return on investment ratio is, is important for making wise decisions. After all, you should expect some rewards for investing your capital. All of the above real estate metrics are great for estimating the profitability of an investment property or for comparing properties to find the one with the most promising financial rewards.
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