For investors who diversify their investment portfolio with real estate, it's important to measure the return on investment (ROI) to determine a property's profitability.
ROI measures how much money or profit is made on an investment as a percentage of the cost of the investment. It shows how effectively and efficiently investment dollars are being used to generate profits.
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 a residential rental property.
The Formula for ROI
Gain on Investment
Cost of Investment
To calculate the profit or gain on any investment, you would first take the total return on the investment and subtract the original cost of the investment. However, ROI is a profitability ratio, meaning it gives us the profit on an investment represented in percentage terms.
To calculate the percentage return on investment, we take the net profit or net gain on the investment and divide it by the original cost.
For instance, if you buy ABC stock for $1,000 and sell it two years later for $1,600, the net profit would be $600 ($1,600 - $1,000). The ROI on the stock would be 60% [$600 (net profit) ÷ $1,000 (cost) = 0.60].
Calculating the ROI on Rental Properties
The above equation seems easy enough to calculate, but keep in mind that a number of variables come into play with real estate that can affect ROI numbers. Those include repair and maintenance expenses and methods of figuring leverage—the amount of money borrowed (with interest) to make the initial investment.
When purchasing property, the terms of financing can greatly impact the price of the investment; however, using resources like a mortgage calculator can help you save money by helping you find favorable interest rates.
ROI for Cash Transactions
If you buy a property outright with cash, calculating its ROI is fairly straightforward. Here's an example of a rental property purchased with cash:
- You paid a $100,000 in cash for the rental property.
- The closing costs were $1,000, and remodeling costs totaled $9,000, bringing your total investment to $110,000 for the property.
- You collected $1,000 in rent every month.
A year later:
- You earned $12,000 in rental income for that year.
- Expenses, including the water bill, property taxes, and insurance, totaled $2,400 for the year or $200 per month.
- Your annual return was $9,600 ($12,000 - $2,400).
To calculate the property’s ROI:
- Divide the annual return ($9,600) by the amount of the total investment or $110,000.
- ROI = $9,600 ÷ $110,000 = 0.087 or 8.7%.
- Your ROI was 8.7%.