Different rental properties will yield different ROIs. That’s why, as a landlord, it’s important to know what to expect when investing in a rental property. Of course, you want to invest in an investment property that yields optimum profitability.
In today’s blog, T.E. Johnson & Sons will teach you how to calculate the ROI on a property investment.
Return on Investment for Long-Term Rentals
A long-term rental is one in which a tenant stays for between several months to multiple years. The rental property can be an apartment, a residential home, or a commercial building.
Generally, the typical return on investment on these investment vehicles is usually between 8- and 12%. With long-term leases, you can expect a consistent rental income and potential for property value appreciation.
Return on Investment for Short-Term Rental Properties
These can be residential or commercial properties, which you can rent out on a short-term basis. They are often listed on Airbnb or VRBO platforms, and can range from an individual room to an entire home.
With short-term rentals, the expected ROI usually depends on the prevailing market conditions. During the peak seasons, ROI can peak at 20%. Whereas, during the off-peak seasons, the ROI can dip to as low as 5 percent.
How to Calculate the ROI on a Property Investment
Before investing in a particular rental investment, begin by crunching the numbers to get an idea of what to expect in profitability.
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The following are three formulas you can use to know the ROI of an investment.
1. Return on Investment (ROI)
This is the most basic calculation of all the three methods of looking at an investment’s ROI. To calculate it, you’ll need to consider the property’s annual rental income and the total cost of investment over the same period.
Let’s say, for example, that you have invested a total of $100,000 in an investment property. And from that, you’ve been able to recoup a profit of $120,000. This, therefore, means that your ROI would be as follows.
- Annual Income from Investment - $120,000. This is the total amount of rent you expect to collect for a year.
- Total Cost of Investment - $100,000. These are the running costs of the property. They can include things like insurance, property taxes, maintenance costs, and any applicable mortgage payments.
- Profit - $20,000. This is what you get after subtracting the annual expenses from the annual rental income.
Formula:
ROI = Annual Profit/Total Cost of Investment X 100.
ROI = $20,000/$100,000 X 100 = 20%.
That said, this formula is pretty simple and isn’t specific enough to provide a clearer picture of how much profit to expect when other factors are considered. For more granular calculations, consider the Capitalization Rate and the Cash on Cash Return formulas.
2. Capitalization Rate (Cap Rate)
Cap Rate is the ratio between the property’s Net Operating Income and the property’s purchase price.
Let’s suppose you are buying an investment property for $185,000. To close on the property, you spend an additional $1,500, and spend another $10,000 to get the property rent-ready. At this point, your total investment would be $185,000 + $1,500 + $10,000 = $196,500.
Let’s also suppose that you’re going to rent out the property at a monthly rent of $1000. At the end of 12 months, this would have potentially earned you $12,000. As for running costs, such as property taxes, maintenance, insurance, and property management, let’s assume they would sum up to $2,000.
If you subtract the annual running expenses from your annual rental income, this would leave you with a profit of $10,000. ($12,000 - $2,000).
Formula:
Cap Rate = Net Operating Income/Total Purchase Price X 100.
Cap Rate = $10,000/$196,500) X 100 = 5.09%.
The 5% cap rate indicates that for every $1 of property value, you should expect the investment to generate $0.05 in net operating income.
3. Cash on Cash Return (CoC)
This formula is slightly more complicated. However, if you’re financing the investment using a mortgage, it may be necessary to use it.
Let’s say, for instance, you are buying a rental property for $200,000. The mortgage financing requires that you put down a 20% deposit ($40,000).
Additionally, you also need to pay the closing costs ($2,500) and the cost of fixing up the property before renting it out ($10,000).
In total, this would mean you’d have spent a total of $40,000 + $2,500 + $10,000 = $52,500.
To calculate the annual cash flow, you’ll need to calculate the monthly profit on the property. If renting out the property for, say, $700 per month, this would amount to $8,400 for the whole year.
Formula:
Cash on Cash Return = Annual Cash Flow/Total Cash Invested X 100.
Cash on Cash Return = $8,400/52,500 X 100 = 16%.
The higher the CoC, the more profitable the investment will be. However, you also need to consider other factors as well, such as the potential growth appreciation and risk involved.
What ROI Percentage Should You Aim For?
This is usually subjective depending on a particular investor’s point of view. This is because no two properties are ever the same. You have to look at the location, potential risks, and location, among other things.
But generally speaking, aim for an ROI of between 8-15%. For a more specific figure, hiring a local expert, such as a seasoned property management company, is probably your best bet.
Conclusion
If you’re contemplating buying your first investment property, or are looking to add an extra unit to your portfolio, getting expert insights is key. We can help you find the property investment of your dreams in the Winston-Salem, NC area.
Additionally, as a full-service property management company, T.E. Johnson & Sons can help you find a reliable tenant to rent to, among other things. Get in touch to learn more; we’d be more than happy to help!
