What Is ROI In Real Estate? How To Evaluate Your Rental Property
Real estate investing can be a great way to earn passive income, but only if you choose the right property. If the property is a bad investment, it can end up costing you a lot of time and money in the long run.
So, if you have your eye on a certain property, how do you know if it’s a good investment or not? The best way to evaluate a property is by calculating the real estate ROI.
What Is Real Estate Return On Investment?
Return on investment, or ROI, is a metric that tells you what kind of profit you'll make on an investment. It compares the amount you’ve invested in the property to its current value.
The ROI helps you understand whether a property you’re looking at will be a “good” investment. For that reason, it’s important to understand how to calculate the ROI before diving into real estate investing.
This measurement is usually expressed as a percentage and you can calculate the ROI using a simple formula. Calculating ROI is relatively easy. Just make sure to include all the factors that contribute to your investment cost to ensure you're getting the most accurate data.
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Understanding The ROI Formula
Mortgage companies and real estate investors use ROI to evaluate the potential returns on a real estate property. Now that you understand what ROI is, you can learn how to calculate it yourself using the following steps.
Determine Your Investment Costs
The first step you need to take is to determine the investment costs for a rental property. You’ll need the following information to determine these costs:
- Property details: Before you can calculate the ROI, you’ll need to know the property value, property repair costs, square footage and number of bedrooms.
- Mortgage details: You’ll also need to have information about the mortgage, like the loan terms, down payment, closing costs and interest rate.
- Rental income details: The monthly income from the property and anticipated vacancy rate can also affect the ROI.
- Monthly rental expenses: The monthly rental expenses include things like maintenance costs, repairs, utilities and HOA
- Annual rental expenses: There may be additional rental expenses to consider, like property taxes and insurance.
Using The ROI Formula
Once you have the information you need, you’ll calculate the ROI using the following formula:
ROI = (Investment gain - Cost of investment) / (Cost of investment)
The first part of the formula tells you your net profits, which is the amount 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 percentage.
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 you prefer, you can also add the equity you have on your property to your investment gains when calculating ROI.
How To Calculate ROI On A Rental Property
When you’re calculating the ROI on a rental property, you also need to consider whether you paid cash or financed the real estate transaction. Each option comes with its own advantages, but it will change how you calculate ROI.
Using The ROI Formula For Cash
If you paid cash, flipped and resold your investment, you’ll calculate the ROI by taking the total net profit and dividing it by your total investment. For instance, let’s say you paid $200,000 for a property and your net profit is $30,000. That means your ROI is 15% because 30,000 divided by 200,000 is 0.15.
Using ROI Formula For Loans
If you financed or took out a loan for the property, you’ll use the following formula:
ROI = (Annual Rental Income − Annual Operating Costs) ÷ Mortgage Value)
Financing the transaction can help investors with out-of-pocket expenses and preserve cash flow, but it can make it tricky to determine the ROI of the property.
ROI Real Estate FAQs
If you still have more questions about how to determine the ROI of real estate, the following frequently asked questions may help.
What is a good ROI in real estate?
A good ROI in real estate is usually anything above 8%. However, there are several factors which can affect the ROI, including the location, rental prices and overall risks involved.
What are the best types of real estate investments for ROI?
If you’re looking for a real estate investment with a traditionally good ROI, you might consider single-family homes, real estate investment trusts (REITs) and multifamily properties.
What is the 1% rule?
The 1% rule is a strategy used in real estate to determine the cap rate. According to this rule, when you’re evaluating real estate properties, the monthly rent should be at least 1% of the total purchase price. If you can meet the 1% rule, you should be able to manage your expenses and generate positive cash flow on the investment.
Besides ROI, how else can you determine investment profitability?
Beyond just using ROI, you can also use the capitalization rate, internal rate of return (IRR), and cash-on-cash returns to evaluate investment opportunities.
Why is ROI important for real estate investing?
ROI is important because it helps you determine an investment’s profitability. If the ROI is too low, the property probably isn’t a good investment and you could end up losing money.
The Bottom Line
If you’re hoping to invest in a real estate property and rent it out to tenants, it’s a good idea to do some planning first. Real estate is a big investment, so knowing how to evaluate a rental property and figure out the ROI will ensure you’ve chosen a worthwhile investment.
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. And if you’re ready to move forward with an investment property, you can start the mortgage approval process today.
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