How to Calculate ROI on Rental Property

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Contributor, Benzinga
September 7, 2023

As with any investment, understanding the total return is essential in building long-term capital and returns. Real estate is a complex market. In addition to positive cash flow from rental income, the property may be appreciating, adding to your potential annual returns. Read on to learn how to calculate ROI on rental property and the primary factors to consider. 

What is Return on Investment (ROI)?

Return on investment (ROI) is a ratio, expressed as a percentage, of an investment's gains or growth compared to its costs. ROI is a significant measure of an investment's performance used to compare diverse portfolio holdings objectively. ROI shows the efficiency of one investment compared to another. ROI is typically calculated annually. Here's a simplified example: 

Suppose you purchase a house for $100,000, invest $20,000 in renovations and repairs, and then resell the property for $180,000. In that case, your return on investment of $120,000 would be $60,000, or 50%. That's an exceptional ROI more likely to be seen in professional house flipper's portfolios.

With a rental property, you'll hold the property long-term, leading to different possible ROI calculations. The most common measures used are cash flow ROI and cap rate, although investors will usually also measure cash-on-cash return and net operating income. Here's how to understand cap rate and ROI.

Capitalization Rate

The capitalization rate, commonly called the cap rate, is used by investors to measure the relative performance of an investment property. The cap rate is the ratio between annual rental income and a property's current assessed asset value, expressed as a percentage. Cap rate is useful for investors because it allows you to consider appreciating property values.  

Cap rate = net operating income / asset value

For example, if you purchase a rental property for $200,000 and earn a net operating income of $20,000, the property's cap rate would be 10%. 

$20,000 / $200,000 = 10%

When assessing possible investment properties, generally, the higher the cap rate, the greater the risk and the faster the payback period. With a 10% cap rate, you will break even on the property value in 10 years. 

Calculating ROI

To begin calculating ROI, you'll want to calculate monthly cash flow. 

Cash Flow = Gross Rent - All Expenses

With this formula, you'll have how much cash you can expect to receive monthly after deducting all expenses, including marketing, property management services, maintenance, property taxes, and insurance.

Next, you'll want to consider the ROI formula used for any investment:

To calculate the percentage ROI, take the net profit, or net gain, on the investment and divide it by the original cost:

ROI =  (Gain on Investment − Cost of Investment) / Cost of Investment

As you'll see below, applying this formula to rental properties requires additional considerations, including whether or not the property is financed.

How to Calculate ROI on Rental Properties

You can use the formula above, but it's important to remember the numerous variables that affect the ROI on real estate, including the repair and maintenance expenses, whether the property was financed, the amount borrowed and the interest on the initial investment. 

If you paid for a property with cash, calculating ROI is relatively simple. First, you calculate net operating income and then plug that number into the ROI formula. Here's an example.

If you purchased a property for $100,000 and invested $20,000 in repairs, closing costs and maintenance expenses, your total investment is $120,000.  If you collected $900 on rent each month, the gross income would be $10,800. If expenses for maintenance, insurance, taxes and utilities for the year totaled $2,000, your total annual return would be $8,800 ($10,800 – $2,000).

Then, you can plug those numbers in to calculate the property’s ROI:

ROI =  (Gain on Investment − Cost of Investment) / Cost of Investment

ROI = ($128,800 - $120,000) / $120,000 = 7.3%

You could also simply write this ROI = $8,800 / $120,000 = 7.3%

Your ROI would be 7.3%. In the case of financed properties, you'll subtract the interest or cost of the mortgage from the gross income to get an accurate ROI. 

What is a Good ROI for Rental Property?

While investors in the stock market will tell you that a standard expected ROI might be 7% and a good ROI might be 10% to 11%, with rental properties, the considerations are more complex. 

For that reason, there's no single good ROI on rental properties. Factors that influence the returns a property generates include:

  • Purchase price
  • Mortgage costs, including down payment, closing costs, interest and monthly payments
  • Rental income
  • Occupancy rates and tenant retention
  • Operating expenses

When looking at good returns on a rental property, investors should first look for positive cash flow. Whether you financed the property or invested cash will also influence target ROIs. For example, if you financed the property, even earning $100 a month while paying off the mortgage, covering expenses and building asset value can be considered good. 

Investors interested primarily in long-term asset growth may be happy with modest cash flow and the assumption that the property will appreciate over time. However, if you're looking for short-term cash returns, most investors look for a minimum of 7%, comparable to recent averages in indexed funds. In the example above, after deducting expenses, you'd earn about $733 per month while earning over 7% ROI without accounting for any appreciation. 

Importance of Understanding ROI on Rental Properties

ROI is important to objectively compare rental properties with other investments to understand short-term and long-term returns. Knowing the ROI allows you to be a more informed investor and accurately compare rental property returns before purchase. 

If a property depreciates or ROI becomes low or negative, this can be an indicator to change strategy or re-consider the long-term value of the investment. 

Factors Affecting the ROI on an Investment Property

Here's a breakdown of the main factors affecting rental property ROI.

Home Equity

Home equity impacts ROI on rentals over the long term. Equity is the market value of the property minus any outstanding loan amount. However, since home equity isn't cash in your bank account, you'd need to sell the property to confirm the assumed value. 

To calculate the amount of equity in your home, review your mortgage amortization schedule to determine how much of your mortgage payments went toward paying down the loan's principal. This builds up the equity in your home.

For example, suppose the property's market value is $250,000, and the outstanding loan principal is $100,000. In that case, you could calculate ROI with a home equity value of $150,000. If you initially invested $30,000, your ROI would be 500%. This calculation can show the growth of asset value even in the cash of break-even cash flow.  

Cash Transactions

For cash transactions, you'll look for ROI on your investment from short-term cash flow and long-term appreciation. If you paid $100,000 for a property, including all closing costs and renovations and made $12,000 net income on the property the first year, your ROI would be 12%.

ROI =  (Gain on Investment − Cost of Investment) / Cost of Investment

ROI = ($112,000 - $100,000) / $110,000 =12%

Financed Transactions

In financing transactions, it's important to calculate the interest rate and associated financing costs into ROI. For example, assume you bought the same $100,000 rental property but took out a mortgage.

The mortgage down payment was 20%, or $20,000. Closing costs with a mortgage were $3,000. If you paid $10,000 for remodeling, your initial investment would be $33,000. 

If you secured a 30-year loan with a fixed 6% interest rate, the monthly payment on principal plus interest would be $762.97. To make an estimate, suppose additional monthly costs like insurance, utilities, taxes and maintenance total $200 per month. That means the total monthly expenses are $962.97.

If the rental is $1,000 monthly, the gross annual income is $12,000. In that case, annual cash flow would be just $444.

To calculate the property's ROI, divide the annual return by the original out-of-pocket expenses:

ROI = $444 ÷ $33,000 = 0.0135

Your ROI is 1.35%. 

However, if the property increases assessed value by an average of 5% yearly, this could still be a good investment even with a low annual ROI from cash flow. Likewise, if you could increase the rent to $1,250, your ROI would increase to 10.4%: 

ROI = $3,444 ÷ $33,000 = 0.104 or 10.4%

Using ROI to Assess Property Returns

Whether buying your first rental property, considering managing rental properties or building a rental property business, ROI offers investors a realistic, objective assessment tool. Taken together with additional real estate assessment tools like cap rate or the 2% rule, you can gauge the performance of rental properties both short-term and long-term. 

Frequently Asked Questions

Q

What is the 2% rule in real estate?

A

The 2% rule is another simple calculation to quickly assess a property’s ROI. By the 2% rule, if the monthly rental income is at least 2% of a property’s purchase price, then it should generate positive cash flow. The formula for the 2% rule is if the monthly rent / purchase price x 100 is greater than 2%, the property should be profitable.

Q

What is the formula for calculating ROI?

A

The formula for calculating ROI is the difference between initial investment and current value, divided by initial investment. It can be calculated like this: ROI =  (Gain on Investment − Cost of Investment) / Cost of Investment.

Q

Can ROI be more than 100%?

A

Yes, ROI can be more than 100%.

About Alison Plaut

Alison Kimberly is a freelance content writer with a Sustainable MBA, uniquely qualified to help individuals and businesses achieve the triple bottom line of environmental, social, and financial profitability. She has been writing for various non-profit organizations for 15+ years. When not writing, you will find her promoting education and meditation in the developing world, or hiking and enjoying nature.

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