As an investor, the most important thing for you is the profit you make on your investment. But when you buy a rental income property, your profit is the money you earn in the form of rent you receive from your tenants. Of course, the value of the property increases over a period of time but you are mainly concerned with its rental income. How much of a ROI can be considered as good for a rental income property? There is no fixed percentage that can be accepted as good ROI. It depends upon many factors such as operational expenses, age and condition of the property, and so on.
ROI for any rental income property is calculated by dividing the annual returns with the cost of investment. ROI is a measure of how well a property is performing for the investor. If your monthly rental income is $5,000 and you have spent $500,000 in purchasing and then another $100000 in its rehab, the ROI from this property for you is 12 X 5000/500000 + 100000 X 100 = 10%
This ROI is when the investor purchases the property in cash out of his own savings. In real estate investing, it is possible to leverage the money of others to buy a property and become its owner while repaying the loan amount in easy installments. This means you can increase the ROI from a rental income property by getting its purchase financed by a lender. Also, it is not correct to say that the ROI from a property when it is purchased in cash is good enough for an investor who buys it through financing.
If you have own money to buy a property
If you are blessed to have money in your bank account to finance the purchase of a property, there is a different formula to calculate ROI from the property. It is called Cap rate and it allows investors to make a comparison between two properties to find out which one is more profitable for them. Cap rate is calculated by dividing net operational income with the purchase price and then multiplying the result by 100. Purchase price is known and so the investor only needs to find out net operational income which is the difference between annual rental income and annual operating expenses. Any Cap rate between 4-10% is regarded as good for investing in rental income properties. However, there are cities like Pittsburgh and Atlanta where average Cap rates are lower than 4% and yet they are considered good for the investors.
In general, the higher the Cap rate, the more profitable the rental income property is for the investor.
ROI for lender financed properties
In real life, no investor is wealthy like a Rockefeller to purchase a property out of his own savings. All transactions are made possible through financing done by lenders. If you are asked to pay a 20% down payment by the lender while the rest of the money is provided by the lender, your cost of investment gets reduced drastically. In such a scenario, the investor needs to use cash on cash instead of ROI to arrive at the real ROI for himself. In this ROI, the investor needs to divide annual returns with total cash that he has invested and multiply the result by 100. It can include not just the down payment but also the entire closing costs and the money spent on the repairs and remodeling of the property.
As you can see, there are different ways to find out ROI for rental income properties. While 5-8% ROI is considered good, investors aim to get 10-12% ROI to turn their investments more profitable.