Many make the mistake of investing in rental properties only to realize that doing so wasn’t a smart move. Why? Forgetting (or not realizing) they need to calculate ROI for a rental property before purchasing.
The term ‘return on investment” (ROI) is critical to all landlords and landlords-to-be.
This article will explain all there is to know about the subject, including how to calculate your ROI for a rental property to ensure that the investment you make, or already have made, turns out to be a profitable one.
What constitutes a return on investment (ROI)?
A return on investment (ROI) is a measurement presented in percentiles that indicates how profitable an investment is. In this case, the investment is the rental property. It’s a factor of great importance to landlords that can help them decide whether acquiring a rental is worth it.
How hard is it to calculate your ROI for a rental property?
The answer to this question largely depends on the purchasing method. For instance, it’s easier to calculate the asset’s ROI if it was bought all in cash. On the other hand, the profitability is somewhat harder to evaluate for the purchases finalized with the mortgage. There are more variables to consider in the case of the latter, thus making the calculation process more complicated.
In both cases, the formula is the same. To find out the property’s ROI, you have to divide the annual return by the amount of the total investment. Of course, you’ll first have to figure out just how much of an annual return you can expect, as well as all the costs of the purchase.
How to calculate ROI for a rental property financed with cash?
The first step towards determining whether your rental asset is profitable is to calculate its annual return. To do so, before all, you’ll have to come up with an amount you wish to rent it out for.
Let’s assume that you are renting out the property for $1,000 a month. Over the course of the year, you are looking to recoup the total of $12,000. Of course, each month, you are in charge of covering certain fees, such as property taxes and insurance. In this situation, let’s say you are dedicating $200 a month towards those. That means that your yearly expenses account for $2,400.
Now that you know your gains and your expenses, it’s time to deduct one from the other and get your annual return. In this example, that’s $12,000 – $2,400, which comes down to $9,600.
Now, let’s talk about the costs of the purchase.
These include the actual price you’ve paid for the property, the closing costs, as well as the remodeling costs. We’ll assume that the property was valued at $100,000, that closing costs were $1,000, and that you’ve also put down $9,000 towards the remodeling project. All of those combined make the total purchasing costs of $110,000.
You’ve got your yearly return and the total investment costs all accounted for and are ready to calculate your ROI. The only thing left to do is to divide the two numbers. Here, that’s $9,600 ÷ $110,000, making the ROI 0.087 or 8,7%.
Calculating the return on investment for a property financed with a mortgage
As for the assets you finance by taking a mortgage, getting to the annual return and the total costs is more complex. In the previous example, the property in question was valued at $100,000, and we’ll use the same one this time, too. If you take out a loan, you won’t be paying the entire amount out of pocket, but you’ll still be required to put down 20% of the value in the form of the down payment, which accounts for $20,000.
As for the closing costs, in the case of mortgages, they are typically higher. For the purpose of explanation, let’s say there are $3,000. Now, let’s say you also want to remodel the place and are willing to spend $7,000 on it. In the end, when you combine all those numbers, you are looking at paying the total of $30,000 straightaway, no mortgage included.
You’ve decided to rent the place at $1,000 a month and are looking at the yearly income of $12,000. You are still obligated to pay the taxes and insurance on a month-to-month basis in the amount of $200, or $2,400 a year.
However, on top of that, you also have the mortgage to take care of. If we say that your monthly installment is $400, that’s actually $4,800 you’re spending on a mortgage per annum. Deduct the ongoing costs from the rental income to get the annual return. Here, that’s $12,000 – $2,400 – $4,800, which ends up being $4,800.
From here on out, it’s easy to calculate your ROI for a rental property, as the formula is the same. Annual return divided by the total costs, $4,800 ÷ $30,000, which puts the ROI down to 0.16 or 16%.
What is considered a good return on investment?
In theory, the higher the return on investment, the better. It’s tough to talk about the ideal percentage, as everybody seems to have a different point of view regarding the subject. However, the rule of thumb suggests that an ROI above 10% is up to most people’s standards. Although, anything between 5% and 10% is also considered acceptable.
Then again, what good is a high ROI if you spend a lot of money on other expenses? One of those expenses might very well be a monthly fee associated with renting out a storage unit. You might need a storage unit to store belongings not currently required on the premises.
However, if you genuinely need one, you’ll have to come up with a way to cut the costs as much as you can. A way to achieve that is to go with a smaller unit, as the costs of renting out such will be lower. By spending less on additional expenses, including storage, you will have gained the most money possible from your rental.
If you are just now investing in your very first property, remember that it won’t make you rich overnight. Being new to the game, there’s so much you are yet to learn. The first step towards success is to calculate your ROI for a rental property. That way, you’ll know for sure if the asset you’ve been eyeing is that – an asset.