As a new investor, you should already be convinced that rentals are a great way to build wealth and achieve financial security and independence. But how do you know whether a particular property is a good investment or not? One good way to determine this is by calculating ROI on a rental property.
In this article, we will teach you how to do just that. We will also discuss some of the factors that you should consider when calculating ROI. So, let’s get started!
What Is ROI on a Rental Property?
Return on investment (ROI) is a measure of how profitable a particular investment is, which is generally calculated by dividing the net profit of an investment by the amount of money that was invested. In a way, it allows you to estimate rental income and tells you how much money you will make or lose on a potential investment.
Obviously, you would want to make as much money as possible. The higher the ROI, the better. So, it’s important to calculate ROI before making any decisions about whether or not to proceed.
Common Parameters in Calculating Rental Property ROI
When calculating rental ROI, there are certain parameters that you need to take into account.
Costs That Come with the Purchase
When you invest in a rental property, you will need to shell out an amount of money for the acquisition.
- Purchase price – Money that you pay for the property.
- Loan – If you take out a loan to finance the purchase, then you will need to include the principal, interest, and any other fees in this amount.
- Closing costs – Fees and expenses that you pay when you buy a property. They typically include things like legal fees, title insurance, and transfer taxes.
Recurring Expenses
These are the expenditures that you have to deal with on a regular basis, whether it is monthly, quarterly, or yearly.
- Maintenance costs – Money that you spend to keep your property in good condition. This covers things like painting, repairs, and landscaping.
- Property taxes – Taxes that you have to pay on your property, which can vary from state to state.
- Insurance premiums – Payments that you make for insurance coverage on your property.
- Management fees – Costs to hire a company to manage your property.
- Mortgage (if applicable) – Monthly mortgage payment on your property.
- Utilities – Expenses that you incur for the use of things like electricity, water, and gas.
- Other costs – There could also be other expenses that come with owning your property, such as homeowners association (HOA) fees, legal fees, and accounting fees.
Income-Related Parameters
These encompass important fields, such as:
- Net operating income (NOI) – Amount of money that you earn from your property after all the expenses have been paid.
- Cash flow – Amount of cash that you receive (or spend) on a property each month. It is calculated by subtracting monthly expenses from monthly income.
- Cap rate – This is how much return you are getting on your investment. It is calculated by dividing annual NOI by the purchase price.
- Vacancy rate – Percentage of time that your property is not rented out.
- Other revenues generated by the property – These could include things like rent from parking spaces, laundry facilities, or storage units.
Calculating ROI on a Potential Property
Now that you know the usual parameters that are used in rental income calculation, it is time to determine your potential returns. There are several methods for calculating ROI on a rental property, but the following are the ones that real estate professionals mostly use.
1. Net Present Value (NPV) Method
This method is a popular way to calculate ROI because it takes all of the relevant cash flows into account. In order to use this method, you can start by calculating the present value of all cash flows. This can be done using a rental profitability calculator or a spreadsheet.
Example:
Let’s say that you are considering investing in a property that has the following numbers:
- Purchase price: $100,000
- Loan amount: $80,000
- Interest rate: 12%
- Term of loan: 30 years
- Closing costs: $2,000
- Maintenance costs: $500/month
- Property taxes: $200/month
- Insurance premiums: $50/month
- Management fees: $200/month
Once you have these figures, you will need to calculate the NPV for each year of the investment. You can do this by multiplying the cash flow by the appropriate discount rate. The discount rate is usually determined by the risk associated with the investment. In this case, we will use a 12% rate.
Now, you can add all of these figures up to get the NPV for the entire investment. This number tells you how much money you would make (or lose) if you were to invest in this property.
2. Internal Rate of Return (IRR) Method
This method is very similar to the NPV method, but it uses only positive cash flows. In order to use this method, you need to know two things: the initial investment amount and the final payoff amount.
Example:
Let’s say that you are considering investing in a property that has the following numbers:
- Purchase price: $100,000
- Loan amount: $80,000
- Interest rate: 12%
- Term of loan: 30 years
- Closing costs: $2,000
- Maintenance costs: $500/month
- Property taxes: $200/month
- Insurance premiums: $50/month
- Management fees: $200/month
Based on these figures, you will need to calculate the IRR for each year of the investment. You can do this by subtracting the cash flow from the initial investment amount and then dividing it by the final payoff amount. The final payoff amount is calculated by adding the closing costs, maintenance costs, property taxes, insurance premiums, and management fees.
3. NOI Method
This would be the most common method used by investors. In order to use it, you need to know the property’s NOI. The NOI is calculated by subtracting the monthly mortgage payment from the monthly rental income.
Example:
Let’s say that you are considering investing in a property that has the following numbers:
- Purchase price: $100,000
- Loan amount: $80,000
- Interest rate: 12%
- Term of loan: 30 years
- Closing costs: $2,000
- Maintenance costs: $500/month
- Property taxes: $200/month
- Insurance premiums: $50/month
- Management fees: $200/month
Using these figures, you can calculate the ROI for each year of the investment. You can do this by dividing the NOI by the initial investment amount.
If working with these numbers seems overwhelming for you, then you can use a property income calculator.
Also read: Wegmans Real Estate for Sale: Your Guide to Making a Sound Investment
Using an Online Rental Property Calculator
Calculating rental returns is now so much easier by using an ROI calculator investment professionals offer. However, there will be a lot of options that are available online today, so which one will you use?
To ensure you will get accurate numbers, you should choose a property rental return calculator that is offered by brokers or agents that most investors trust. It is also important to use a calculator that has been updated recently because the market conditions are always changing.
If a property is on a mortgage, there is also a mortgage calculator investment property experts provide for free that you can use.
Final Thoughts
Investing in rental properties can be daunting, but you can make things easier when you have the numbers figured out. By calculating ROI on a rental property for each potential option, you will have a higher chance of making the wisest decision and buying a property that will truly suit your lifestyle and investment goals. With the information provided in this article, you should now feel confident about finding properties that will give you the best bang for your money.
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