Running the financial calculations on a property is a crucial step before the actual purchase. With careful calculations, you will know whether the property is a good investment or whether it will be a drain on your finances. While you cannot predict everything, you can discover enough to calculate a good estimate of income, expenses and your return on investment (ROI).
Return on investment is a key financial measure of profitability used to measure the profitability of an investment or to compare investments. ROI is a basic ratio of the gain from the investment with respect to the cost, expressed as a percentage. While it is not the only metric used to evaluate a real estate investment (more on that later), it is an important one.
ROI % = (Net return on investment) / (cost of investment) X 100
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How to Calculate ROI in Real Estate
In one sense, calculating real estate ROI is an easy task. At its most basic level, it’s defined as profit or income minus expenses. The calculation is simple: (Gain on Investment – Cost of Investment) / Cost of Investment.
Another way to determine ROI real estate is: ROI % = (Net return on investment) / (cost of investment) X 100.
But while the math for determining real estate ROI is easy, you can still run into a lot of pitfalls while trying to tabulate your real estate return potential. For instance, consider that a particular property’s income isn’t fully comprised of received rent. It may include fees you levy on the tenant for services provided and secondary income streams (e.g., laundry facilities, vending machines). Additionally, make sure to include all applicable expenses. We discuss these expenses in a following section, but some examples include insurance and taxes, management fees, utilities, improvements, maintenance and services. Failing to properly account for your expenses or income can cause you to dramatically underestimate real estate risk and acquire unprofitable investments.
Calculating ROI is an essential part of analyzing the financial performance of real estate investments. There are several approaches to estimating ROI in real estate, including cash flow ROI calculation, cash-on-cash return, cap rate and net operating income. Here’s how each approach works:
Cash Flow ROI Calculation
The cash flow ROI calculation is a simple way to evaluate the returns on a real estate investment. This approach divides the annual cash flow from the property by the total investment. The formula for calculating cash flow ROI is:
(Cash Flow from Property / Total Investment) x 100
For example, if the annual cash flow from a rental property is $20,000, and the total investment in the property is $200,000, then the cash flow ROI would be: ($20,000 / $200,000) x 100 = 10%
This means the investment generates a 10% return on the total investment each year.
The cash-on-cash return is a more detailed approach to evaluating the financial performance of a real estate investment. This approach involves calculating the annual cash flow generated by the property and dividing it by the amount of cash invested in the property. The formula for calculating cash-on-cash return is:
(Annual Cash Flow from Property / Total Cash Invested) x 100
For example, if the annual cash flow from a rental property is $20,000, and the cash invested in the property is $100,000, then the cash-on-cash return would be: ($20,000 / $100,000) x 100 = 20%
This means the investment generates a 20% return on the cash invested each year.
The cap rate is a popular approach to evaluating the value of an income-producing property. The cap rate represents the rate of return on the property based on the income it generates. The formula for calculating the cap rate is:
(Net Operating Income / Property Value) x 100
For example, if the net operating income from a property is $100,000, and the property value is $1,000,000, the cap rate would then be: ($100,000 / $1,000,000) x 100 = 10%
This means that the property generates a 10% return on the investment.
Net Operating Income
Net operating income (NOI) is the income generated by a property after operating expenses are deducted. The formula for calculating net operating income is:
Total Revenue – Operating Expenses = Net Operating Income
For example, if the total revenue generated by a property is $200,000, and the operating expenses are $50,000, then the net operating income would be: $200,000 – $50,000 = $150,000
By calculating the net operating income, investors can evaluate the financial performance of the property and make informed investment decisions.
Each of these approaches to calculating ROI in real estate provides valuable insights into the financial performance of an investment property. Using these approaches, investors can evaluate the risks and returns associated with a property and make informed investment decisions.
Common Rules and Guidelines for Investing in Real Estate
Real estate investors have developed a set of rules that help determine whether a property will be profitable, how much you should pay for the property, and the minimum rent you need to charge. Using these rules helps you estimate the basic financial potential of the property. Here are a few of the most common rules applied to real estate investments:
- 1% Rule – The 1% rule is a quick calculation that allows the purchaser to compare income to mortgage payments: (purchase price + cost of repairs) X .01 = minimum rent or max mortgage payment. It does not take maintenance and other expenses into account.
- 2% Rule – The 2% rule provides a rough initial measure of the cash flow potential of a property. The guideline is that a property is usually a good investment if the rental income is above or equal to 2% of the purchase price: (monthly rental rate) / purchase price X 100 >2 %. If the % value is 2% or higher, the property will most likely provide positive cash flow.
- 50% Rule – The 50% rule tells us to expect to pay approximately half of the income generated for operating expenses (not including the loan payment).
- 70% Rule – This guideline for flippers states that the most you should pay for a property is 70% of the after-repair value minus the cost of repairs. Maximum purchase price = (After-repair value x .70) – repair cost.
These rules are general guidelines for real estate investment and do not tell the whole story. They are useful in the initial stages of investigating a potential real estate investment to determine whether it is worth further investigation. They are not a guarantee of profit since many more factors affect the investment.
What is a Good Rate of Return on Rental Properties?
There is no hard and fast rule on what is a good ROI on rental properties. Many variables are involved. For example, the size of the property, location and associated risk all affect the acceptable ROI. Anything above 15% ROI is considered a great investment, and 10% to 15% is considered a good ROI on rental properties. Most experts state that the average real estate ROI ranges from 9% to 10%, and average commercial real estate ROI often edges up to around 11%. Private equity real estate ROIs (i.e., REIT-like investments tailored for high-net-worth individuals that aren’t subject to certain regulations) are much more volatile. They can produce double-digit gains — or substantial losses.
Single-Family vs. Multifamily Real Estate Investments
Whether you should buy single-family properties or more substantial multifamily investments depends on your goals, your financial resources and many other factors. Many investors start with a single-family investment, which is typically more affordable and easier to finance. After gaining some experience in real estate investment and dealing with tenants, they move up to multifamily investments, which usually generate higher incomes. This can be an excellent way to build your portfolio without taking on too much risk in the beginning.
Factors and Considerations in Determining ROI
We previously mentioned factors that impact ROI, but here is a more comprehensive list. While you can never predict all associated costs in advance, you can prepare by being aware of the typical costs investors encounter. These may apply to your property:
- Mortgage, property taxes, and insurance
- HOA fees
- Repairs and daily maintenance
- Property management fees
- Marketing fees
- Property improvements
- Closing costs and other transaction fees
- Pest control and other specialized services
As the owner, you are responsible for all of these expenses. By planning ahead and considering them before you purchase the property, you will have a better idea of how valuable your property can be.
Drawbacks to Interpreting Value through ROI Alone
As previously noted, the different ways of calculating ROI can lead to subtly different results. ROI is a financial metric that only considers the returns generated by the investment relative to the investment cost. It does not take into account non-financial factors that impact the value of the investment, such as market trends, location and the quality of the property. A second, related drawback is that individuals can define commonly understood concepts such as “profit” in multiple ways, making specific ROI results less than reliable if you don’t know the specific method by which they were determined.
A third issue with ROI is that it completely ignores the impact of time. ROI measures the return generated by the investment in a given period, but it does not consider the time value of money. For example, an investment that garnered a 50% return over a six-month period looks identical on paper to one that realized a 50% return over, say, 10 years. But the elapsed period is anything but insignificant when choosing between different investments! Similarly, ROI measures the returns the investment generated based on the current market conditions and performance. It does not account for future changes in the market or investment performance that may impact the investment’s value. ROI can also be affected by short-term fluctuations in the market or investment performance, which may not be representative of the long-term potential of the investment.
Other metrics may be more applicable to your specific situation, including:
- Determining your return on invested cash alone (Cash on Cash Return = Annual Pre-Tax Cash Flow / Total Cash Invested).
- Determining your return based on how much equity you have in the property (Return on Equity Real Estate = (Income – Expenses) / (Fair Market Value – Mortgage Balance).
- Determining your property’s value comparable to similar properties on the market (Capitalization Rate = Net Operating Income / Fair Market Value).
- Determining whether or not a particular property will meet or exceed a desired return (visit Investopedia to learn how to calculate Net Present Value).
The Importance of ROI for Real Estate
The drawbacks identified here do not negate the importance of using ROI in real estate contexts. Because a carefully determined ROI can easily conform to accounting measures, how to calculate rental income for taxes becomes just a part of calculating ROI. Also, because ROI is relatively easy to understand and calculate, it’s more or less a standard industry measure. Are you wondering what is a good yield on a rental property? The answer you get will most likely be an ROI calculation. What about the average returns a rental property will produce? Again, expect to receive a ROI. In order to participate in real estate investment, this is one metric you absolutely have to know.
What Type of Real Estate Investment Has the Highest ROI?
As discussed in a previous section, the average real estate investment return is around 10%. Average rental property returns may tick higher or lower, as may investments in commercial sites and single-family homes. So while commercial properties may generally offer higher returns, you can’t exactly say that they have the “highest” ROI. The real estate investment with the highest ROI is likely that special deal that you happened upon and which may be a once-in-a-lifetime opportunity — and it could be anything.
If you need help finding these kinds of real estate investment properties or calculating any of these costs for your property, we would be happy to help. GNP Realty Partners is experienced in every aspect of real estate investment and management. Think of us as a partner with a passion for helping you achieve your investment goals. Call us today at 312-329-8400 or contact us to learn how we can help you.
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