Before buying an investment property, you want to make sure you’ll make money off it.
One way real estate investors evaluate investment profitability is by calculating return on investment, or ROI, which measures cash return expressed as a percentage of total investment cost on an annual basis.
You can calculate ROI yourself using a simple formula, or you can use a real estate investment return calculator.
What is real estate investment return?
ROI in real estate refers to the amount of invested money you regain — your cash flow — after associated cost deductions. It is expressed as a percentage of your total invested capital.
Associated cost deductions (expenses) in real estate include loan premiums, interest, taxes, insurance, property management fees, homeowner’s association fees (if applicable), and any other applicable expenses, such as home repairs and maintenance.
Savvy real estate investors know that vacancy is another variable affecting cash flow, so when they calculate ROI, they subtract income they expect to lose through vacancy from their projected annual cash flow. Most investors expect vacancy rates of 5 to 10 percent.
How do you calculate ROI for a rental property?
The ROI formula is simple:
ROI = Annual Cash Flow / Invested Capital
Before calculating ROI, you need to get some numbers together to calculate your annual cash flow (you should already have an idea of the amount of your invested capital).
To calculate annual cash flow, you’ll need your monthly rental income, your monthly expenses, your monthly cash flow, and your vacancy losses.
First, you need your monthly cash flow, which you calculate simply by subtracting monthly expenses from monthly rental income. Multiply your monthly cash flow by 12, and then subtract your vacancy losses from the product to get your annual cash flow. Once you have your annual cash flow, divide it by the amount of your invested capital to get your ROI.
Let’s use an example to illustrate this calculation. Say you financed a $350,000 single-unit rental property with a 20 percent down payment of $70,000 — your invested capital. You plan to charge a $2,500 monthly rent. Further, you expect to pay $1,400 in expenses. Finally, you expect (for simplicity’s sake) the property to be occupied all year (no vacancy losses).
Your monthly cash flow:
$2,500 − $1,400 = $1,100
Your annual cash flow:
$1,100 × 12 = $13,200
$13,200 / $70,000 = 0.19 (19 percent)
Real estate investment return calculator
The internet has produced a dozen free real estate investment return calculators. This one by SparkRental performs the calculation above and even calculates your mortgage payments and vacancy losses for you.
What is a good rate of return for real estate?
Among real estate investors, the general belief is that 8 to 12 percent is a good ROI, and anything above 12 percent is excellent. But every investor is different.
Some conservative investors might consider a 6 percent ROI decent while more liberal investors might consider 20 percent or less a total failure. At the end of the day, your expectations define what a good ROI is.
The bottom line
Calculating ROI is only one part of finding the right real estate investments. Head over to our guide on investing in real estate to learn more.