A real estate investment is a great way to safeguard and grow your wealth. Real estate has the unique capability of conserving your wealth, appreciating value, and providing a dependable source of passive income.
As one prepares to invest in rental property, it is a good idea to weigh any risks against the potential reward. One of the ways to do this is by calculating a property’s return on investment. The return on investment, or ROI, is a measure of a property’s profitability as a percentage of the initial financial investment.
Finding the ROI of a rental property is crucial to know if the property will make a healthy profit or if you’ll be operating at a loss.
For this reason, our team at Paramount Management & Realty prepared this article on how to calculate your property’s ROI. Our goal is to help you understand how you can analyze the returns on your rental property.
Investment Properties in the Market
Before going into calculating ROI, it’s important to understand what types of property are available. When it comes to rental property investment, there are different types of properties that one can choose from.
These include single-family homes, multi-family buildings, apartment complexes, townhouses, duplexes, triplexes, and others. These properties offer a reliable source of income but they each have different requirements.
As an investor, you can also decide if you’d like to have a short-term or long-term rental. In order to make the most of property investment, you need to know your budget and have a clear understanding of your investment goals. These goals will also help you build and maintain a better landlord-tenant relationship.
After you’ve identified a rental property, there are certain details that you need to know so as to calculate your ROI. This includes:
You need to know as much as possible about the property itself. This includes the square footage, the property value, the number of bedrooms, and any repair requirements. These specifics will provide insight into the property’s potential and any related costs.
Specific mortgage details are important in calculating the cost of financing the property. It is necessary to know the terms of the loan, the down payment, the payment period, the interest rate, and other details. A mortgage reduces your initial costs but the payments will be deducted from your rental income.
There are certain monthly expenses associated with running a property. These may include repair and maintenance costs, utility bills, and dues for the local HOA. These costs can also reduce your monthly income and need to be factored into calculating the ROI.
Annual Property Expenses
There are also some expenses that occur on a yearly basis. Examples of such include insurance and property taxes.
A property’s rental income is what covers the costs and expenses of the property, and it may provide you with additional profits. Knowing the rental income is imperative in finding out the true potential of the investment. You’ll also need more information on the anticipated vacancy rate and other sources of income.
How to Find the ROI of a Rental Property
When calculating the return on investment for rental real estate, we first take the annual returns of the investment and subtract the total costs. This will give us the net profit earned by the property. We then divide the net profit by the original investment to find the ROI.
This formula is straightforward if the property transaction was made in cash. However, if the transaction involved debt financing, you’ll need to include the loan payments as part of the monthly costs. The ROI for a financed rental property tends to be higher because the initial investment was lower.
Apart from the traditional ROI formula, there are other methods you can use to calculate the returns on a rental property. They include:
The Net Operating Income
The net operating income, or NOI, is a figure that indicates your property’s profitability on a monthly basis. It can be found by subtracting the operating expenses from the gross income.
This metric is found by dividing the after-tax annual cash flow and the original investment cost. The ratio obtained represents the expected return as a percentage of what you initially invested. It is a good indicator of a rental property’s financial performance.
The Capitalization Rate
The capitalization rate (or cap rate) of a property represents the returns you can expect from your rental property. This figure is obtained by dividing the annual net operating income by the purchase price of the property. The cap rate shows you what percentage of the purchase price you can recover in a year and it is a good metric for comparing investment properties.
The Gross Rent Multiplier
The annual gross rent multiplier, or GRM, is a metric used by investors to find out if the seller has a reasonable asking price for the property. It can be obtained by dividing the total sales price by the annual gross rent.
The Annual Cash Flow
This figure is obtained by subtracting the debt from the net operating income. It shows how much profit your rental property earns in a year after all the expenses and mortgages are paid off.
The metrics mentioned above are a good way to measure the financial performance of a property. When it comes to the ROI, the recommended percentage is normally above 10%. But investors can sometimes accept a rate of between 5% and 10%. The rate of returns is however dependent on the level of risk associated with the investment.
When it comes to property investment, it is prudent to find out as much as you can about the property you’d like to purchase. Calculating a rental property’s ROI can help you find the one with the most promising returns year after year. This can help you to grow your wealth and enjoy a consistent source of passive income.
At Paramount Management & Realty, we have a professional team that is dedicated to meeting your property management needs. With our depth of experience, we can help your property achieve its best potential. Connect with us today for unparalleled property management services in Phoenix, AZ.