In searching for the answer to what is a good ROI (return on investment), many beginner real estate investors expect someone to give them a number. 5%? 10%? 50%? To clarify, there is no single number to label as the best ROI on rental properties. Real estate investing is just not that simple.
However, determining what is a good ROI for income properties doesn’t have to be complicated either. As long as a real estate investor takes the time to understand what the return on investment of income properties depends on and how to calculate it, he/she can easily come to the answer of what is a good ROI.
What Is a Return on Investment in Real Estate?
To start at the beginning, a return on investment is a way of measuring the performance of real estate investment properties. It’s the return or profit a real estate investor gets on the cash investment made. Essentially, it’s the money made from the income properties in comparison to the actual cash invested. The ROI can be calculated with the following formula:
ROI = (Annual Net Profit/Total Cash Investment) x 100
What Is a Good ROI?
In order to come to a conclusion about what is a good ROI, a real estate investor has to understand all of the factors that affect the return on investment of income properties.
Location in the Real Estate Market
It’s no surprise that the location of income properties in the real estate market has the biggest impact on what is a good ROI. This is simply because what is a good ROI for one location in the real estate market may not be a good ROI in another. Let’s take a look at how this is possible in real estate investing:
Location #1
An investment property in one neighborhood costs $250,000. After monthly investment property expenses are accounted for, the net monthly rental income is $1,000. Using the return on investment formula above, this investment property has an ROI of 4.8%.
What is a good ROI for this neighborhood? Is it 4.8%? Real estate investment properties require a high cash investment in this neighborhood. This is likely because they are in high demand, from both real estate investors and tenants. This means that the rental income from these income properties will produce a reliable and steady cash flow. Before reaching the final verdict on what is a good ROI, let’s look at a different location in the real estate market.
Related: Location Location Location: What Makes for The Best Place to Invest in Real Estate?
Location #2
A similar investment property in a different city in the real estate market costs $195,000. After deducting property expenses, the monthly rental income is also $1,000, as the income properties in this example are very similar. The ROI would be 6.1%. This neighborhood seems to bring a better return on investment for income properties.
However, in this neighborhood, demand for rental property is generally low, hence the lower property price. It’s not the best neighborhood, it requires long drives to get to commercial or job centers, and the unemployment rate is somewhat high for this real estate market.
Comparing the two locations, what is a good ROI? It would seem that for location #1, the lower return on investment for income properties is a good one, considering the other factors of the location that bring about success for a rental property. For location #2, it would seem a real estate investor would need a higher ROI (meaning a lower cash investment) in order for the rental property to be a success in the long run. This is due to lower demand and possibly higher vacancy rates. An ROI lower in either location #1 or #2 would be considered a bad ROI; anything higher would be the answer to what is a good ROI in those specific locations.
Types of Real Estate Investment Properties
Just as the location in the real estate market affects what is a good ROI, the types of real estate investment properties do as well. Different real estate markets have a different demand for different investment properties. It would follow then that the types of income properties will affect what is a good ROI in specific real estate markets.
A single family home in one real estate market (like in a popular city center), for example, may need to have a return on investment of 8% to be any kind of success. In the same location, a multifamily home with higher demand may only need an ROI of 5%.
To start looking for and analyzing the best real estate investment properties in your city and neighborhood of choice, click here.
Risk of Real Estate Investing
What is a good ROI depends on one thing based on what we’ve seen: risk. If a real estate market or an investment property is of high risk, a real estate investor needs to aim for a higher return on investment. If they represent a low risk real estate investment, then a lower ROI would be considered good in the long run.
It would seem then that what is a good ROI is subjective. It takes thorough investigation of the real estate market and investment property in order to decide.
How to Calculate ROI
You should know how to calculate return on investment using more popular real estate metrics than the simple ROI formula given above. This will get you closer to the answer to “what is a good ROI?”
Cash on Cash Return
Cash on Cash Return = Annual Cash Flow/Cash Investment
To break down the cash on cash return formula further:
Annual Cash Flow = Gross Rental Income + Other Income – Vacancy – Operating Expenses – Debt
Cash Investment = Down Payment + Closing Costs + Pre-Rental Repairs on Investment Properties
Gather all the necessary information on a rental property through investment property analysis, and you should be able to calculate cash on cash return.
What is a good cash on cash return? Most real estate experts agree anything above 8% makes for a good cash on cash return. When you answer what is a good cash on cash return, you also get the answer to what is a good ROI.
Need help with these calculations? Use Mashvisor’s investment property calculator to quickly calculate cash on cash return for multiple investment properties in the real estate market.
To learn more about how we will help you make faster and smarter real estate investment decisions, click here.
Learn More: What Is Cash on Cash Return?
Cap Rate
Cap Rate = Annual Net Operating Income/Property Price
The difference between the cap rate formula and the cash on cash return formula all comes down to the investment property loan. For the cap rate, the investment property loan is not considered in the annual net operating income. The property price is determined by real estate market analysis, and the cap rate is calculated.
What is a good cap rate? The first way to find this out is to look at the cap rate for a general location. A real estate investor can easily find this data from an investment property calculator. A good cap rate for a rental property would be anything equal to or above the median cap rate of the location. To give it a number, real estate experts suggest 5% or above.
Find Out: What Is a Good Cap Rate for Investment Properties?
So, What Is a Good ROI for Rental Property?
A good return on investment, then, depends on many different factors. While you may not get a general answer, it’s not difficult to find out once you start your investment property search. Thoroughly investigate the location in the real estate market and the type of rental property to determine whether they represent high or low risk real estate investing. Then, calculate cash on cash return and cap rate. What you’ll have is the complete picture in order to know what is a good ROI for any of your future real estate investments.