People enter the real estate business looking for the same thing, and that is profit. Making money is the main purpose of real estate investors, and the only way to make money in real estate is to get a good return on your investment. However, many wonder what is a good return on investment? This, as many other important questions in this field, has no straightforward answer. In most cases, the answer to the question “What is a good return on investment?” is “It depends.” So, let’s look at some of the possible answers to one of the most important real estate investing questions – “What is a good return on investment in the real estate business?”.
How Do You Measure Return on Investment in the Real Estate Business?
To answer this question, you first need to conduct a comparative market analysis and measure how much money you will be making from your income property. There are 3 widely used methods for calculating return on investment in the world of real estate investments.
Related: Real Estate Market Analysis: The Basics
3 Ways to Measure Return on Real Estate Investment
1. Return on Investment (ROI)
The return on investment is a measure which is used to evaluate the efficiency of an investment. Many successful real estate investors and real estate experts consider it to be the most important number when it comes to the return on real estate investment.
The formula for measuring ROI is:
ROI = Annual rental income/Total cash investment
For example, you buy an investment property for $400,000 and pay another $15,000 in closing fees, maintenance costs, etc., then you charge a monthly rent of $2,500. The ROI for this income property is:
ROI = 12 x $2,500 / ($400,000 + $15,000) = 7.2%
Now, going back to our main question: What is a good return on investment in terms of ROI?
The answer depends on a number factors such as the size of the property, the location, and the risks associated with this investment, in addition to each investor’s goal. Some real estate investors will probably be happy with a ROI of 7.2% on an investment property; however, others with riskier properties would not settle for anything less than 40%. On average, anything above 15% of return on investment is considered a good return on real estate investment.
2. Capitalization Rate
The cap rate (short for capitalization rate) is another popular metric for assessing return on real estate investment. It is based on the net operating income (NOI), and it describes the rate of return of a rental property regardless of the method of financing.
The formula is simple:
Cap rate = NOI/Price
Let’s say it costs you a total of $170,000 to buy an income property, and you rent it out for $1,500 per month. All annual costs related to your property add up to $3,000. To calculate the cap rate:
Cap rate = (12 x $1,500 – $3,000) / $170,000 = 8.82%
So, what is a good return on investment in relation to cap rate? Once again, there is no clear answer to this question; it all depends on various aspects of the asset type, the property size, the market, and others. Nevertheless, there is a general agreement among real estate investors that a good cap rate is anything above 10%.
Related: What’s a good cap rate for investment properties?
To know more about what is a good cap rate for your particular investment property, you can use Mashvisor’s investment property calculator which provides you with the cap rate for thousands of properties and entire neighborhoods throughout the US real estate markets.
3. Cash on Cash Return
A third widely used metric for determining the profitability of a real estate investment is the cash on cash (or CoC) return. Unlike the cap rate, CoC return measures the annual return on your investment based on the NOI and the total cash investment. Moreover, the answer to the question what is a good return on investment is not as clear, given that CoC return varies depending on the method of financing.
The formula is as follows:
CoC return = NOI/Total cash investment
Let’s say you purchased a rental property worth $350,000 through a mortgage, with a 20% down payment (or $70,000). You charge tenants $1,800 per month, and your annual expenses associated with the property add up to $4,000.
CoC return = (12 x $1,800 – $4,000)/$70,000 = 25.1%
However, let’s see how CoC return differs if buy the same property fully in cash:
CoC return = (12 x $1,800 – $4,000)/$350,000 = 5.0%
As you see, the CoC return is going to change drastically if you change your financing method.
Now, to know what is a good return on investment, we need to know what is a good cash on cash return for investment properties. Similar to the rest of real estate metrics, the cash on cash return also varies from one kind of investment property to another, and from one location to another. Experts disagree on the numbers; some say that anything above in the range 8-12% is good. Successful real estate investors would not even consider a rental property if it doesn’t provide them with 20% of cash on cash return.
Conclusion
As mentioned above, what is a good return on investment depends on the characteristics of the actual property and the local housing market. You can expect a higher return from a riskier, larger, and more luxurious income property. But before making any final decisions, even successful real estate investors still need to conduct an in-depth real estate market analysis, and investment property analysis to guarantee the return on investment that you are looking for.
Now that you know the answer to what is a good return on investment with regards to ROI, what is a good cap rate, and what is a good cash on cash return, these numbers together can help decide which property is the right for you to make money in real estate investing.
Don’t forget to use Mashvisor when browsing for an investment property and conducting a comparative market analysis. With just a click, Mashvisor filters listed properties by the capitalization rate and the cash on cash return as well as the rental income, for both traditional rent and Airbnb throughout the US. Ultimately, Mashvisor helps you find the best investment properties that meet your requirements and needs as a real estate investor.