Real Estate ROI: How To Appraise Rentals And Calculate Your Returns
Maybe you’re looking at the first building block of your real estate empire. Or perhaps you’re in good financial shape and just want to purchase a home that can earn you a little passive income. Whatever the case, you’ve found yourself in the market for your first investment property.
How do you decide if the property you've got your eye on is a good investment? Read on to learn how to appraise rentals and calculate ROI to make the best move for your portfolio.
What Is ROI In Real Estate?
Return on investment, or ROI, is a metric that tells you how much profit you'll make on an investment. ROI helps determine what a “good” investment is, so understanding how to calculate it is essential before you dive into real estate investing. ROI is like cap rate, another metric used by investors to estimate profitability.
This measurement is usually expressed as a percentage. Calculating ROI involves a simple formula. Includes all the factors that contribute to your investment cost to make sure you're getting the most accurate data.
How To Appraise Rentals
To determine your return on investment, you'll need to have a solid idea of how much a property will cost and how much you'll be able to rent it for. That's where appraisals come in.
For rentals, there are two parts to this: the valuation of the property itself and the determination of rental value.
Valuing The Property
The first part of an appraisal on a rental property covers the same territory as any other appraisal: putting a value on the house. The specific guidelines the appraiser must follow depend on the type of home you’re getting. But that said, the framework remains pretty much the same, so let’s cover the major property value guidelines.
Let’s say you’re looking at a property that has three two-bedroom units. Your appraiser will look for sales of similar three-unit properties in your area to help determine the fair market value of the home you’re considering. These are called comparables, or comps. They help the appraiser determine a reasonable sales price in the current market conditions.
Determining Rental Value
Once the basic appraisal is in place, the appraiser can turn their attention to what a fair monthly rental payment would look like based on the market. Let’s take a look at how that process works.
First, your appraiser will calculate an adjusted monthly rent by finding comparable properties in your area. The appraiser will note information about the lease as well as the monthly rental price of each comp, minus the cost of any utilities and furniture.
Once this baseline is established, it’s adjusted up or down to account for factors that make your property different, such as:
- Location/view considerations
- Design and appeal of the property
- Age and condition
- Room count and square footage
- Special features, like a basement
For multi-unit properties, there’s a form that, although not identical, takes into account many of the same factors.
Filling Out The Operating Income Statement
If you happen to be buying your investment property through a conventional mortgage from Freddie Mac, the appraiser will fill out an operating income statement with you. In addition to discussing the rental income you’ll make every month, this includes a projection of your annual expenses for things like utilities and upkeep. Upkeep includes the cost for repairs, replacing any appliances, etc.
Factoring In Your Mortgage Payments
When you buy an investment property, you may want to use the rental income to help you qualify for the monthly mortgage. If that’s the case, you'll need to take the estimated rental value from your appraiser into consideration.
Whatever you charge for rent, you can only use 75% of that money to qualify for your new mortgage payment. The rest is a vacancy factor, which accounts for the time it takes to find new renters if your current renters move.
How To Calculate ROI For Your Rental Property
Now that we’ve looked at how mortgage companies evaluate potential returns for the purposes of an appraisal, maybe you’re wondering how you as an investor can do some quick math to judge the value of a potential real estate investment. This is where ROI comes in.
Adding Up Your Investment Costs
Before plugging values into an ROI equation or calculator, it's important to make sure you're taking all of your costs into account. If you're investing money that you aren't tracking, you won't get an accurate picture of your actual returns.
If you're buying your property with cash, the purchase price will simply be the cash value of the house. If you take out a mortgage, you'll need to factor in your down payment and monthly principal and interest contributions.
Some other costs to consider include:
The exact amount will never be constant due to changes in property taxes and homeowners insurance, along with the fact that maintenance costs tend to fluctuate from year to year.
However, property owners can anticipate losing around 5% – 10% of their net operating income every year to expenses. You may be able to judge whether you’re likely to be on the low or high side of that range based on the area in which you live and the age of your home.
Using The ROI Formula
Once you have your inputs, ROI is calculated using the following formula:
ROI = (Investment gain - Cost of investment) / (Cost of investment)
The first part of the formula gives you your net profits, or what you have left over after you subtract your total costs from your total gains. You'll divide that value by the total costs to express your ROI as a percent. So, if you enter your numbers into the formula and get a result of 0.07, that means you're seeing a 7% return on your investment.
If desired, you can also add the equity you have on your property to your investment gains when calculating ROI.
What Is A Good ROI?
What investors consider “good” can vary wildly. For some, it's important to shoot as high as possible, while others believe an investment is worth it if they can match average returns. Many investors consult the S&P 500, which provides an average return of about 8%. By this standard, an ROI of 8% or greater would be considered a good one.
The Bottom Line: Think Before You Buy
Ready to start investing in real estate? If your plan is to purchase property and rent it out to tenants, a little planning can go a long way in helping you determine whether a potential investment is worthwhile.
If you're still searching for the perfect property, you can increase your chances of getting a great ROI by researching the best cities for real estate investment.
Ready to go ahead and make a move on your investment property? Get started today and apply for your mortgage online.