How to Calculate ROI on a Rental Property
Why It’s Important to Know a Property’s ROI Before Buying Real Estate
One of the main reasons people invest is to increase their wealth. Although the motivations may differ between investors—some may want money for retirement, others may choose to sock away money for other life events like having a baby or for a wedding—making money is usually the basis of all investments. And it doesn’t matter where you put your money, whether it goes into the stock market, the bond market, or real estate.
Real estate is tangible property that’s made up of land, and generally includes any structures or resources found on that land. Investment properties are one example of a real estate investment. People usually purchase investment properties with the intent of making money through rental income. Some people buy investment properties with the intent of selling them after a short time.1
Regardless of the intention, for investors who diversify their investment portfolio with real estate, it’s important to measure return on investment(ROI) to determine a property’s profitability. Here’s a quick look at ROI, how to calculate it for your rental property, and why it’s important that you know a property’s ROI before you make a real estate purchase.
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What Is Return on Investment (ROI)?
Return on investment measures how much money, or profit, is made on an investment as a percentage of the cost of that investment. It shows how effectively and efficiently investment dollars are being used to generate profits. Knowing ROI allows investors to assess whether putting money into a particular investment is a wise choice or not.
ROI can be used for any investment—stocks, bonds, a savings account, and a piece of real estate. Calculating a meaningful ROI for a residential property can be challenging because calculations can be easily manipulated—certain variables can be included or excluded in the calculation. It can become especially difficult when investors have the option of paying cash or taking out a mortgage on the property.
Here, we’ll review two examples for calculating ROI on residential rental property: a cash purchase and one that’s financed with a mortgage.
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The Formula for ROI
To calculate the profit or gain on any investment, first take the total return on the investment and subtract the original cost of the investment.
To calculate the percentage ROI, we take the net profit, or net gain, on the investment and divide it by the original cost:
For instance, if you buy stock for KSH129,000 and sell it two years later for KSH 206,400 the net profit is KSH 77,400 (KSH 206,400 – KSH 129,000). ROI on the stock is 60% [KSH 77,400 (net profit) ÷ KSH129,000 (cost) = 0.60%.
Calculating ROI on Rental Properties
The above equation seems simple enough, but keep in mind that there are a number of variables that come into play with real estate that can affect ROI numbers. These include repair and maintenance expenses, and methods of figuring leverage—the amount of money borrowed with interest to make the initial investment. Of course, financing terms can greatly affect the overall cost of the investment.
ROI for Cash Transactions
Calculating a property’s ROI is fairly straightforward if you buy a property with cash. Here’s an example of a rental property purchased with cash:
- You paid KSH 12,900,000 in cash for the rental property.
- The closing cost were KSH129,000 and remodeling costs totaled KSH 1,161,000, bringing your total investment to KSH 14,190,000 for the property.
- You collected KSH129,000 in rent every month.
A year later:
- You earned KSH 1,548,000 in rental income for those 12 months.
- Expenses including the water bill, property taxes, and insurance, totaled KSH 309,600 for the year. or KSH 25,800 per month.
- Your annual return was KSH1,238,400 (KSH 1,548,000 – KSH 309,600).
To calculate the property’s ROI:
- Divide the annual return (KSH1,238,400) by the amount of the total investment, or KSH 14,190,000.
- ROI = KSH 1,238,400 ÷ KSH 14,190,000 = 0.087 or 8.7%.
- Your ROI was 8.7%.
ROI for Financed Transactions
Calculating the ROI on financed transactions is more involved.
For example, assume you bought the same KSH 12,900,000 rental property as above, but instead of paying cash, you took out a mortgage.
- The downpayment needed for the mortgage was 20% of the purchase price, or KSH 2,580,000 ($12,900,000 sales price x 20%).
- Closing costs were higher, which is typical for a mortgage, totaling KSH 322,500 upfront.
- You paid KSH 1,161,000 for remodeling.
- Your total out-of-pocket expenses were KSH 4,063,500 (KSH 2,580,000 + KSH 322,500 + KSH1,161,000).
There are also ongoing costs with a mortgage:
- Let’s assume you took out a 30-year loan with a fixed 4% interest rate. On the borrowed KSH10,320,000, the monthly principal and interest payment would be KSH 49,268.97.
- We’ll add the same KSH 25,800 per month to cover water, taxes, and insurance, making your total monthly payment KSH 25,800
- Rental income of KSH129,000 per month totals KSH1,548,000 for the year.
- Monthly cash flow is KSH 53,931.03 (KSH129,000 rent – KSH 75,068.97 mortgage payment).
One year later:
- You earned KSH 1,548,000 in total rental income for the year at KSH129,000 per month.
- Your annual return was KSH 647,172.36 (KSH 53,931.03 x 12 months).
To calculate the property’s ROI:
- Divide the annual return by your original out-of-pocket expenses (the downpayment of KSH 2,580,000, closing costs of KSH 322,500, and remodeling for KSH 1,161,000) to determine ROI.
- ROI = KSH 647,172.36 ÷ KSH 4,063,500 = 0.159.
- Your ROI is 15.9%.
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Home Equity
Some investors add the home’s equity into the equation. Equity is the market value of the property minus the total loan amount outstanding. Keep in mind that home equity is not cash-in-hand. You would need to sell the property to access it.
To calculate the amount of equity in your home, review your mortgage amortization schedule to find out how much of your mortgage payments went toward paying down the principal of the loan. This builds up the equity in your home.
The equity amount can be added to the annual return. In our example, the amortization schedule for the loan showed that a total of KSH181,740.36 of principal was paid down during the first 12 months.
- The new annual return, including the equity portion, equals KSH 828,912.72 (KSH 647172.36 annual income + KSH 181,740.36 equity).
- ROI = KSH 828,912.72 ÷ KSH 4,063,500 = 0.20.
- Your ROI is 20%.
The Importance of ROI for Real Estate
Knowing the ROI for any investment allows you to be a more informed investor. Before you buy, estimate your costs and expenses, as well as your rental income. This gives you a chance to compare it to other, similar properties.
Once you’ve narrowed it down, you can then determine how much you’ll make. If at any point you realize that your costs and expenses will exceed your ROI, you may need to decide whether you want to ride it out and hope you’ll make a profit again—or sell so you don’t lose out.
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Other Considerations
Of course, there may be additional expenses involved in owning a rental property, such as repairs or maintenance costs, which would need to be included in the calculations, ultimately affecting the ROI.
Also, we assumed that the property was rented out for all 12 months. In many cases, vacancies occur, particularly in between tenants, and you must account for the lack of income for those months in your calculations.
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