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Having a solid understanding of how to calculate ROI for real estate investments can help you determine whether a rental property is a good investment or has the potential to turn into a money pit. As with any market, the rental market is prone to fluctuations, so calculating ROI projections is useful for predicting whether you’ll be able to succeed. Of course, it’s critical that you do your due diligence when considering a real estate investment. So, when you’re assessing a rental property, here’s what you need to know about calculating its ROI in order to have a better idea about the true potential of your future investment.
First, what is ROI for Rental Properties?
For the uninitiated, ROI is short for return on investment. In other words, it shows how much money/profit you’ll make on your initial investment and is typically shown as a percentage over the cost of your investment.
One of the difficulties with calculating ROI for rental properties is that the formula can be prone to misinterpretation and manipulation. For example, you can include or exclude certain variables (like costs) in the calculation. Beyond that, your ROI will be affected by your financing, whether you’re using a hard money loan, or paying in cash for the property.
How to Calculate ROI on a Rental Property
You can begin to get a basic idea of your ROI for a rental property by following these four steps:
1). Determine your potential annual rental income
2). Assess your cash flow
3). Calculate your net income
4). Find the ROI by dividing your net income by your total upfront investment.
How to Gather Accurate Numbers
Before you calculate your ROI, don’t forget to consider your upfront expenses in addition to recurring expenses. Initial investments usually include your closing costs, down payment, interest rate, and any associated repairs/renovations that are necessary to get your property move-in ready. Following that, you’ll want to analyze your ongoing expenses so that you can compare them with your expected rental income. These expenses typically include property maintenance, insurance, taxes, and other related fees.
This is the point where many investors tend to underestimate their numbers. Of course, you want to minimize costs and assume that you won’t need to set aside as much money for ongoing expenses, but it’s best to be prepared in the event that vacancy occurs. Consider setting aside roughly 10% of your monthly rental income towards expenses related to vacancies and 5% for repair and maintenance expenses for a newly rehabbed unit.
The Basic ROI Formula
Here’s the basic formula: ROI = (annual return/net gain [gain on investment – cost of investment]) / (cost of investment)
What is a good ROI for rental properties?
Unfortunately, there isn’t a steadfast answer for determining a solid ROI for a rental property. That being said, there are some general rules most real estate investors adhere to since certain ROIs may not be financially worth the effort. Specifically, you should aim for your rental ROI to be 5% or more since this percentage means that you’ll earn a higher rate of return compared to other forms of investment.
Getting a 5% to 10% return for rental properties is pretty reasonable. That is, assuming you’ve included higher expenses for vacancies, repairs, and other costs. Of course, the higher the percentage, the better—just make sure to be thorough in your calculation.
If you feel confused or lost at any point when you’re determining potential ROI, it may be worthwhile to consult with a professional.
Other Considerations
Once you’ve factored in all the necessary expenses from owning a rental property, you’ll want to ensure your numbers are as accurate as possible. If you plan on financing your property: the lower your down payment, the larger your ROI, but your loan balance will be higher. This means that leveraging financing can boost your ROI for the short term since you’ll have lower initial costs.
Whenever you calculate your ROI for multiple properties, be sure that you use a consistent approach so that you can accurately compare which one is best suited to add to your portfolio.
Final Thoughts
Calculating the ROI for a new potential investment property requires an investor to take a lot of factors into consideration. Once you’ve acquired the initial numbers, don’t hesitate to research more to determine whether the property will be a solid addition to your portfolio. Don’t forget that every real estate market is different and that the above guidelines may not be 100% accurate for every situation.
About RCN Capital
RCN Capital lends to real estate professionals, commercial contractors, developers & small business owners across the nation. We provide short-term fix & flip financing as well as long-term rental financing for real estate investors, and that includes multifamily properties. RCN Capital also has flexible and competitive loan options available. If you are a real estate investor looking to secure financing for a multifamily property, RCN Capital is the lender that you are looking for. Connect with us today to discuss your next real estate investment.