Real estate is a well-known money-making industry, but it's important to understand the basics before investing. One essential skill is calculating the rate of return for a potential property, which can help you determine its efficiency.
Return on Investment (ROI) is the go-to tool for evaluating investment performance, and can be calculated for different properties to aid in comparison. However, it's important to be cautious when doing these calculations as ROI can be easily manipulated. Additionally, factors such as paying cash versus taking out a mortgage can impact the value of ROI. To accurately calculate ROI, we will discuss different methods here.
A simple formula to calculate Rate of Return
As a real estate investor, it's important to know a simple formula for calculating the rate of return. Here it is:
ROI: (Gain from Investment - Cost of Investment) / Cost of Investment
For example, if you invested $60,000 and made a profit of $80,000, your ROI would be ($80,000 - $60,000) / $60,000 = 0.33 or 33%.
However, this formula is based on estimation and there are other methods to consider. One example is the Cap Rate calculation for ROI, also known as the capitalization rate. This formula is used to calculate the profitability of a property and compare the efficiency of different real estate investments. It's calculated by dividing the net operating income (NOI), which is the difference between rental income and operating expenses, by the purchase price of the property. The formula for cap rate is:
Cap Rate: Net Operating Income / Purchase Price
It's important to note that the Cap Rate formula is based on the assumption that the property was purchased entirely with cash, and doesn't take into account any financing costs or mortgage payments.
Another method to consider is the Cash-on-Cash return, which takes into account the financing costs associated with the purchase of the property. This formula is calculated by dividing the annual cash flow by the amount of cash invested.
Cash-on-Cash Return: Annual Cash Flow / Cash Invested
These methods can provide a more accurate picture of the return on investment for a particular property, but it's important to use them in conjunction with other metrics and factors when evaluating a potential investment.
Cap Rate: NOI /Purchase Price x 100%
This formula is also simple to calculate. Suppose you brought a property, and you paid $ 100,000 cash amount for that. $1000 was the closing cost of this property, and you paid $9,000 for remodeling. The total cost of the rental property is $110,000 now. Now we come to the income, and your tenant pays you $ 800 per month. The yearly income is $ 9,600. We have to deduct some expenses from this money, like property tax, insurance, maintenance charges, etc.; suppose these charges are $2,000 per year. So, your annual income is $ 7,600.
Now, you can use the cap rate formula and divide the annual return, which is $7600, by $110,00, our total investment. Now the calculation will be
Cap Rate: ($7600/$ 110,000) x 100% = 6.9 %
The Rate of return for your rental property is 6.9%
Cash on Cash return calculations for ROI
This method is slightly complex as compared to previous methods. This method calculates the rate of return on investment when investors take a loan or mortgage. The cash on cash or CoC ratio is the annual NOI of that property and the amount of cash you have invested. So, the formula for calculations will be
Cash on cash return = (Annual cash flow /Total Cash invested) x 100%
Suppose you have not paid the cash to buy the property. Instead, you have only paid 20% of the down payment, and the rest is the loan. The costs involved here will be $20,000, which you have paid as a down payment. In addition, $2,500, which is the closing cost of the property, and $900 is the remodeling cost. This total cost is $ 31,500. Now you have mortgaged the property, so the monthly interest will also be part of your calculation. Assume that you have to pay $500 interest. If your renters pay $800 per month, your share will be $300 only as $500 will be taken by the loan provider. After one year, your net annual income will be $3600. Now we can use the same old formula to calculate ROI.
Cash on cash return = (3,600/31,500) x 100 % = 11.4%
This is the rate of return on your property.
Investment property calculators can help.
If you are afraid of these complex calculations, you can get property calculators online. There are various platforms, which offer accurate property calculators. They have inbuilt formulas according to different situations. These calculators are considered the best tools to calculate return on investment. Free options are also available, but they are not reliable.
Is there any ideal rate of return for a rental property?
This is a common question which every investor asks. But various factors determine the rate of return. These factors can be the size of the property, its location, risks involved with the purchase, etc. however, if the rate of return of your rental property is above 15%, we will consider it reasonable. If you use cap rate calculations, the ROI of more than 10% is considered as good. Similarly, experts will call it a good investment on the cash-on-cash return calculator if your answer is 8 to 12 %.
As a property investor and landowner, you must know these calculations about return on investment. You can buy a property by paying the total cash or can mortgage it too. Use the appropriate calculator to know ROI. You can also use online sources for easier and quicker calculations. However, make sure you include all the variables in your calculations. If these statistics are correct, you can choose a suitable investment at the right place. If the ROI is less than 8%, try not to invest in this property. Most people go for 20%, but anything above 12% is worth investing.