Rental Investors- Here’s your first study sheet! Probably best to print this out and highlight certain areas and exercises.
Understanding the numbers behind a Rental Investment Property
In this article we’ll discuss your return on investment (ROI); how to calculate ROI; how to analyze a rental market; options for investment properties, and exit strategies.
What is ROI
ROI, or return on investment, is one of the essential metrics for real estate investors to consider when evaluating a potential property purchase. It measures how much money an investor can expect to make from their investment, compared to how much they have invested in it.
To calculate ROI for a rental property, you must first determine what your initial investment is. Your initial investment includes the amount of money put down at purchase and any additional costs associated with closing and preparing the property for tenants. Additionally, investors should factor in any renovation costs, including materials and labor, to arrive at an accurate number.
This is a very important step!
ROI, or return on investment, is one of the essential metrics for real estate investors to consider when evaluating a potential property purchase. It measures how much money an investor can expect to make from their investment, compared to how much they have invested in it.
To calculate ROI for a rental property, what makes up your investment. The initial investment includes the amount of down payment at purchase (which for investors is typically at least 20%) and any additional costs associated with closing and preparing the property for tenants. Additionally, investors should factor in any renovation costs, including materials and labor, to arrive at an accurate number.
EX: a $300k investment property will require at least $60k down; plus roughly $5k on closing costs and some additional amounts towards appraisals or inspections; and then any amount to get the property rent ready.
Step 1: Determine The Initial Investment
Determining the initial investment is the first step to calculating your rental property’s ROI. Your initial investment includes not just the amount of money put down at the time of purchase but all additional costs associated with closing and preparing the property for tenants.
Purchase Price Of The Property
The property’s purchase price is one of the most important factors to consider when calculating ROI. It is the initial investment put into the property and gives investors an idea of how much money they have to work with to make a profit. It’s important to remember that this includes any closing costs or other fees.
In this stage it’s very important to determine the type of property you will buy. Do you want big monthly cash flow? Do you want large annual appreciation? Do you want to consider short term rentals? Pay attention to HOA fees on condo/townhomes.
Closing Costs
Closing costs are any additional fees associated with the purchase of a property. These can include inspection fees, title insurance, registration fees, and legal and escrow services. Closing costs typically amount to about 1-3% of the total purchase price and are due at closing time.
Rehabilitation/Renovation Costs
Repairs and renovations are necessary to ensure that the home is suitable for tenants and can bring in rental income. These costs can include things like painting, replacing flooring, fixing plumbing or wiring issues as well as updating appliances.
Step 2: Determine The Annual Income
The next step in calculating your rental property’s return on investment is determining the annual income generated from the investment. Calculate yearly income by adding up all the rental income received from tenants over 12 months and subtracting any ongoing expenses associated with operating and managing the property.
Monthly Rental Income
Typically, the most significant portion of a rental property’s annual income will come from the monthly rent collected from tenants. Rental income should include all additional fees received with renting the property, such as late fees, short term fees and pet fees but not refundable deposits.
Ongoing Expenses
Once you’ve calculated your annual income, you’ll need to add up your yearly expenses. These include marketing costs, property management fees, property taxes, and maintenance.
Marketing: The cost of marketing a rental property, such as advertising and tenant screening fees.
Property Management: The cost for a property manager to oversee the daily operations of the rental property.(Usually 8-10% of rent)
Property Taxes: The annual taxes that are due on rental properties to maintain ownership.
Landlord Insurance: Even if you aren’t living at the property, you still need to carry insurance (especially if you have a lien). Landlord insurance covers any liability and repairs on the property due to fire, lightning, wind, hail, or other covered losses.
Maintenance: Any repairs or maintenance costs incurred during the year.
Annual income calculation
To calculate your annual net income subtract your total expenses from your total income. This calculation will give you the yearly profit made by the property. We’ll use this figure in the final step to determine the actual return on investment of the property.
It is important to remember that this figure does not include potential capital gains that may be realized when the property is sold at a later date.
Step 3: Calculate the ROI
Now that you have your annual net income and how much money you put into purchasing the property, you can do the final calculation to determine the actual return on investment. The formula for this is (annual net income/total investment)*100 = ROI.
Calculation of ROI With An All Cash Purchase
Let’s use an example to show exactly how this formula works.
Let’s say you purchased a rental property for $200,000 cash, and the total cost of closing and rehab was $15,000. Your out-of-pocket investment is $215,000
Between basic rehab and finding a tenant, you rent the home for 11 months out of the year for $1,800 per month. This monthly rent equates to a total annual income of $19,800.
Next, you had $5,500 in annual expenses between taxes, maintenance, insurance, and property management.
Your annual net income from this property is $14,300.
To calculate your ROI, we would use the formula: ($14,300/($200,000 + $15,000)) X 100 = 6.65%.
Calculation of ROI With A Financed Purchase
Let’s do another example but instead of using cash for the entire purchase, let’s see how financing affects the ROI.
Let’s say you purchased a rental property for $200,000 and the total cost of closing and rehab was $15,000. You took a 30-year loan out for $160,000, so your out-of-pocket investment is $55,000. ($200,000 + $15,000 – $160,000)
Between basic rehab and finding a tenant, you rent the home for 11 months out of the year for $1,800 per month. This monthly payment equates to a total annual income of $19,800.
Next, you had $16,300 in annual expenses between your mortgage payment, taxes, maintenance, insurance, and property management.
Your annual net income from this property is $3,500.
To calculate your ROI, we would use the following formula: ($3,500/($55,000)) X 100 = 6.3%.
Factors That Can Impact ROI
Some additional factors that can impact your rental property’s ROI include:
Financing Terms: Different financing terms, such as shorter loan periods or lower interest rates, can increase your ROI.
Vacancy rate: The more frequently the unit is occupied, the higher your ROI will be.
Major repairs (sometimes called Capital Expenditures): If a major repair or renovation must be done to the property, it can lower your ROI.
Length of time held: Over time, your ROI can decrease as you accumulate equity in the property. After a couple of years, I like to recalculate my ROI based on the total equity I have in the property because this is a more accurate representation of the money I have “invested” in the property at that time.
How To Interpret The ROI
In the Triangle market currently, An ROI of 5-6 % is considered a good return on investment, and over 6% is very good right now.
Conclusion
In conclusion, calculating the Return on Investment of rental property requires three steps:
Obtaining all relevant financial information for the purchase and rehab costs.
Determining how much income you’ve generated from renting out the property.
Using this figure in the final step to determine the actual return on investment.
This should give you a good idea as to how your investment shall fair in the market!