Investing in real estate serves various purposes, whether for long-term financial stability, saving for life’s milestones, or generating extra income. All these objectives share a common goal: financial growth.
In real estate, wealth can be built through different avenues. For instance, in residential rentals, you may focus on appreciation, equity growth, and cash flow. Alternatively, shorter-term gains can be pursued through strategies like BRRRR or fix-and-flips.
Regardless of your chosen strategy, smart real estate investors gauge a property’s profitability through Return on Investment (ROI). Understanding ROI, mastering its calculation for rental properties, and recognizing its significance are crucial for making informed investment decisions.
This guide provides an in-depth exploration of rental property ROI, highlighting its potential to lead to success in real estate investment.
What does BRRRR mean?
BRRRR, short for Buy, Rehab, Rent, Refinance, Repeat, is a strategic approach to real estate investment.
Most investors usually use loans when buying a property. However, experienced investors know there’s a more efficient way.
Think of it this way: if someone asks for your picture, you’d want to look your best before sending it, right? Similarly, in real estate investing, it’s essential to ensure your property is in prime condition before seeking a loan. Taking out a loan and then renovating the property is like sending your picture before getting all dressed up. This post explains why this order matters, how it enhances your financial outcomes, and why successful investors adopt this strategy.
What Is A Good Rate Of Return On A Rental Property?
The rate of return on your real estate investments can vary significantly based on various factors. These factors include your initial investment, rental income, location, and local expenses like property taxes, management fees, and financing.
In the end, what constitutes a “good” ROI depends on your specific rental business setup and objectives. Nevertheless, as a rough estimate, many investors target an ROI ranging from 8% to 12%.
Is there a way to calculate the ROI on BRRRR property investments?
Return on Investment (ROI) is a vital measure for assessing the profitability of investments and how they convert funds into monetary gains.
Whether you’re investing in stocks, bonds, savings accounts, or real estate, ROI provides a standardized way to judge the wisdom of allocating your funds to a specific investment. In the real estate sector, where you have various investment options, understanding and calculating ROI are essential for making well-informed decisions.
However, determining a meaningful ROI, especially for rental properties, can be challenging due to numerous variables. These variables include the purchase method (cash or mortgage), operating costs, expected cash flow, and potential renovation expenses.
How can I calculate my ROI on a rental property?
ROI, or Return on Investment, represents the return you can expect from your investment. When someone talks about a 10% return on their investment, they’re essentially referring to ROI. In real estate, it’s often called “cash on cash.”
Now, let’s get to the math (but it won’t be complicated). To calculate ROI, you take your yearly profit and divide it by your investment amount.
For real estate, you would take your monthly cash flow, multiply it by 12 (to annualize it), and then divide it by your down payment.
(Cash Flow x 12) / (Down Payment)
It’s a straightforward formula with just two basic numbers. Understanding this concept is crucial because, as investors, our goal is to improve our ROI. If you don’t understand something, you can’t improve it. That’s why they say knowledge is power.
When evaluating rental properties, ROI is often calculated by subtracting annual operating costs from annual rental income and then dividing the result by the mortgage value or the remaining loan amount. The formula is simple:
ROI = (ANNUAL RENTAL INCOME – ANNUAL OPERATING COSTS) / MORTGAGE VALUE
There’s also the cap rate method, calculated as:
CAP RATE = NET OPERATING INCOME / PURCHASE PRICE × 100%
This method considers both the property’s net operating income and its purchase price. Another approach is the cash-on-cash return, calculated as:
CASH-ON-CASH RETURN = (ANNUAL CASH FLOW / TOTAL CASH INVESTED) × 100%
This formula takes into account the property’s annual cash flow and the total cash investment.
Choosing the method that best suits your rental property analysis is essential. If you prefer a financial calculator, tools like the Landlord Studio rental yield calculator can be valuable.
Examples: Calculating ROI on Rental Properties
Although the equations mentioned earlier may seem simple, it’s crucial to consider how real estate variables can affect ROI calculations. Variables like repair and maintenance costs, as well as your financing and leverage, can have a significant impact on ROI figures. To illustrate, let’s explore two examples of calculating ROI for a rental property.
The Importance of ROI for Real Estate
ROI, or Return on Investment, is vital for making well-informed decisions in real estate investments. Before making any purchase, it’s essential to estimate costs, potential rental income, and overall expenses related to the property. This enables you to make meaningful comparisons with similar properties.
Evaluating the potential returns is crucial for assessing an investment’s profitability. If, at any point, it becomes evident that costs may exceed the expected ROI, careful consideration is necessary. You might choose to hold onto the property with hopes of future profits or sell to minimize potential losses.
Consideration must also be given to possible vacancies during periods when the property remains unrented, along with unexpected expenses like repairs and maintenance. These factors need to be factored into your calculations as they can significantly impact the overall ROI.
Real estate investors have the option to diversify their portfolios and maintain ROI through pooled investments, like real estate investment trusts (REITs). These vehicles provide broader exposure to the real estate market and offer a consistent return on investment.
The Bottom Line
Calculating ROI for rental properties differs from other investments, mainly due to factors like financing and cash payments. A smaller initial cash payment with a larger mortgage balance can lead to a higher ROI, while a larger upfront cash payment with less borrowing often results in a lower ROI. Financing can provide a temporary boost to ROI by reducing initial expenses, although it may affect cash flow.
For a comprehensive understanding of your investment portfolio, consistency in measuring ROI across multiple properties is crucial. If you include a property’s equity in the evaluation of one property, the same should be done for other properties when calculating the ROI for your real estate portfolio. This comprehensive approach ensures a thorough grasp of your investment performance.
Leveraging the tools offered by Landlord Studio, such as precise income and expense tracking, detailed real estate reporting and analytics, and maintenance management, equips you with everything necessary to optimize your rental property management and maximize your ROI.